The latest round of inflation data has come in hotter than expected:
- On February 13th, we found out that CPI increased by 0.3% in January (vs 0.2% expected) while core CPI, which excludes food and energy prices, increased by 0.4% (vs 0.3% expected).
- On February 16th, PPI surprised in the same direction by rising 0.3% in January (vs 0.1% expected), with core PPI rising 0.5% (vs 0.1% expected).
One month’s worth of data hardly makes a trend. Monthly data is notoriously noisy and susceptible to quirks related to seasonal adjustments. The main trend for inflation is still down, and our analysis makes us confident that it is going to stay that way as we progress through the year. Yet, these surprises were enough to cause some sizeable moves in the market, as investors were forced to consider the possibility that the Fed may not begin cutting rates until the second half of the year, versus the prior expectation that rate cuts may come as soon as May.
While the short-term implications of hotter-than-expected inflation may seem obvious (higher inflation = rate cuts postponed = bad), the longer-term implications are more nuanced. In fact, some inflation can be good for the stock market, as long as companies have pricing power. One good proxy for pricing power is the spread between CPI and PPI, which has historically correlated with trends in profit margins. The interpretation is straightforward: CPI can be viewed as a proxy for companies’ selling prices, while PPI can be viewed as a proxy for companies’ production costs. When the former rises faster than the latter, margins expand. Historically, when the CPI-PPI spread was greater than 2%, profit margin estimates for the S&P 500 index expanded by an average of 0.68% over the following 12 months. Compare this with a margin contraction of -0.09% when the spread was negative. Currently, the CPI-PPI spread is running at 4.2%, which is near the top of the range that has been in place for the last few decades, and strongly suggests that profit margins are set to expand going forward.
Here is the bottom line: Margin expansion is expected to be a key driver behind the earnings recovery in 2024 and beyond. Current inflation trends, namely the CPI-PPI spread, are consistent with this scenario. And whether the Fed ends up cutting rates in May or July should do very little to change that.
Source: CW Advisors, Bloomberg, as of 2/21/2024
Source: CW Advisors, Bloomberg, as of 2/21/2024
Sauro Locatelli CFA, FRM™, SCR™
Director of Quantitative Research
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