A good inflation reading for corporate profits

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Thursday, May 13, 2021

It's all about demand.

Inflation data published Wednesday left markets spooked.

Consumer prices rose at the fastest annual pace since 2008 in April, according to the latest data from the BLS, news that sent stocks tumbling with the S&P 500 (^GSPC) falling 2.1% on the day.

The simplest read on the market's reaction to this data is that higher inflation will lead to earlier rate hikes from the Fed and all else equal higher rates are worse for stocks. This leaves the stocks that have done best — in this case tech stocks — most vulnerable. But in thinking about the "why" driving April's price increases, it becomes less clear that this data is so reflexively negative for the stock market. Janney's chief fixed income strategist Guy LeBas said Wednesday that this data is yet another reflection of what we've covered in the last several editions of the Morning Brief: rising demand.

"There just isn't a good historical analog for today's core CPI print in the post-70s era," LeBas said. "I can tell you that what it represents is consumer demand rebounding faster than the economy can create supply in the short term. That's a good thing for corporate profits."

Major sources of the price increase in April included the used car market, lodging away from home, and airfares. Flush consumers looking to move around more and travel is a straightforward re-opening theme.

And as the team at Bank of America Global Research said in a note Wednesday, "more persistent sources of inflation were tamer. Rents and OER both came in at 0.2% mom, which is relatively in line with the recent trend." The firm added that, "medical care inflation was flat as the boost from stimulus around the turn of the year faded."

Prices rising in sectors of the economy that were severely impacted by the pandemic while housing and medical costs remain tame is exactly what Fed officials mean when they say inflation pressures are likely to be "transitory."

At the end of 2020, we argued that the reason for the market's rally amid a global pandemic was driven by the same factor that over the long run always drives stock prices — higher earnings. The ability for firms to exert operating leverage after a recession and also raise prices into a strong demand environment are two positive bottom-line dynamics for corporates today.

That today's inflationary backdrop should power future earnings growth does not, of course, mean that investors must or should or will price in this dynamic. And as Wednesday's action made clear, the market's interpretation of the most recent inflation data is that higher rates are coming sooner than expected.

Wall Street economists in our inbox on Wednesday also seemed to agree that even higher inflation readings are coming in the months ahead.

As those reports stack up, questions about whether the Fed will hold its nerve and still refer to these inflation pressures as "transitory" will only grow louder. How the market handles those data points is anyone's guess.

But at least for one month, a jarring inflation report still fits cleanly with an economic theme that could not be more clear: this is a demand-driven recovery.

By Myles Udland is a reporter and anchor for Yahoo Finance Live. Follow him at @MylesUdland

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