Wall Street is becoming increasingly bearish. According to the Morgan Stanley strategists led by Michael Wilson, the market sell-off could continue through the end of the year. A plunge of more than 20 percent is looking like a real possibility. Wilson’ mid-2022 S&P 500 target of 4225 is down about 3 percent from here. 

“What good news is left?” asks Savita Subramanian’s Bank of America team. She predicts the S&P 500 will rise only 4 percent between now and the end of 2022. Her long-term valuation model indicates negative returns over the next decade (–0.8 percent annualized returns) for the first time since the dotcom bubble. 

Behind the cautious outlook is wage inflation and supply-chain disruptions weighing on corporate margins, and higher interest rates posing headwinds to extended valuations. Add to that the observation that global equities have never rallied so much, nor credit spreads tightened so quickly, in the year following a recession.

Earnings for S&P 500 companies have beaten analysts’ estimates by double-digit percentages since the second quarter of 2020. That compares to a median beat rate of 5 percent going back to 2008. With the persistence of supply challenges and labor shortages around the country, strategists see downside risks to earnings amid rising inflationary pressure.

Almost half of the management teams of S&P 500 companies mentioned cost pressures during their second-quarter earnings calls—more than any time in the last ten years. Wilson interprets this to mean that profit margins will contract, as they have in the past when many businesses complained about inflation. “There’s a potential for an earnings recession,” he warns.

Source: Alliance Bernstein

Our fundamental point of view is totally different: people are underestimating the adeptness of the US corporate sector to protect margins and grow profitability despite acute labor shortages and supply-chain challenges. The combination of pricing power and productivity gains will support earnings overall.

A good example is Costco. On the September 23 earnings call, CFO Richard Galanti cited port delays, container and component shortages, Covid disruptions, raw-material and ingredient shortfalls, labor cost pressures, and the unavailability of trucks and drivers. He describes, however, pockets of resilience: 

Despite all these issues, we continue to mitigate cost increases in a variety of different ways and hold down and/or mitigate our price increases passed on to the members. We’ve chartered three ocean vessels for the next year to transport containers between Asia and the US and Canada. And leased several thousand containers for use on these ships. 

We’ve got strong relationships and good buying power with our vendors. When we’re eating a little bit into something, we’re asking, in some cases, for them to eat a little bit into it. We’re constantly figuring out where are there any cost savings to offset some of the cost increases, whether it’s packaging or whatever it might be. 

From Costco’s point of view, inflation’s range has jumped from 1-to-1.5 percent in March to today’s 3.5-to-4.5 percent. But, Galanti said, margins have mostly stayed steady as some inflation has been passed through. Costco reported $3.76 in earnings per share on $62.7 billion in sales. Wall Street was looking for EPS of $3.58 on $61.4 billion in sales. 

Source: Reuters

Toymakers Hasbro and Mattel say they’ll still meet their full-year earnings forecast despite worsening delays at every level of the global supply chain. Here, too, price increases should cover cost inflation.

As for global automakers, a worsening semiconductor shortage is hampering output, but BMW boosted its profit expectations. The impact of lower sales will be offset by higher car prices.

Microsoft, Nestle, Visa, Mastercard, and a slew of other companies say they plan to raise prices in 2022. Others like UPS have a “laser focus” on cost and productivity. “The early results from our productivity initiatives are putting us well on our way to achieving the high end of our 2023 targets,” CFO Brian Newman said. 

Of course, that’s not the entire picture. Some companies have been forced to slash forecasts. Nike, for example, lost ten weeks of production on the back of factory closures in Vietnam. Its 2022 revenue estimates were revised downward—its earnings were not, however. 

Nike CEO John Donahoe points to price hikes and more profitable digital channels for his prediction that gross margin expands by 125 basis points. This will more than offset roughly 100 basis points of additional cost from transportation, logistics and airfreight.

Nike missed revenue expectations in the latest quarter but sold more goods to shoppers at full price, boosting profits. The company has also been reducing its reliance on wholesale partners that often sell at a markdown.

Kohl’s achieved record Q2 earnings and its highest operating margin in a decade, going on to raise earnings expectations for the full year. Its CEO expressed confidence that costs would be handled through increased store productivity and efficiency across all other areas of the business. Nevertheless, Wall Street downgraded the stock, citing supply-chain risks ahead of the holiday season. Is this shortsighted?

The price of moving a forty-foot container from China to the US West Coast jumped to almost $20,000 in September—a more than tenfold increase on pre-pandemic levels. However, shipping costs are coming down now. Long-term rates for the same route are below $5,000. That’s how we know we’ve reached the pinnacle of supply-chain stress. 

Source: Financial Times

Aren’t we all aware of what happens in an inflationary environment? Someone pays for it, and it’s generally the consumer. Price rises are passed on until he or she says, “Ouch, I’m not going to buy anymore.” 

For the time being, consumers are in great shape and demand is strong, so we aren’t at the end of the profits cycle. All that remains is for us to be more patient with supply.

The Russell 2000 has been in a sideways trend since February, the Dow has been unchanged since April, and the S&P 500 has been flat since June. Rather than forming a dangerous top, we believe the averages are consolidating ahead of another strong upward surge.