Earnings Outlook: Corporate Pricing Power Is Driving Earnings

Summary

• Strong earnings so far suggest that equities can keep pushing higher for now.
• But much of that strength is coming from an extraordinary surge in corporate pricing power.
• The risk scenario for equities is that higher prices feed into inflation and then higher wage demands, making the Federal Reserve (Fed) more hawkish.
• But this scenario will take months to play out.
• We caution investors who are long equities to be vigilant for signs that the Fed will turn more hawkish.

What We Learned Last Week

We have been neutral on equities for months, thinking that for now there is little to push major indices above or below the trading ranges of the past year.

However, Q1 earnings season is prompting a rethink. Many companies have apparently been able to pass on price hikes well above inflation. The most mind-boggling examples are the major consumer staples companies – the likes of Procter and Gamble (PG). PepsiCo, Coca-Cola (KO), McDonalds (MCD), and Archer Daniels (AMD) announced price increases in the 8-12% range!

The pattern is much broader. Rail companies CSX (CSX), and Norfolk Southern (NSC) expressed confidence that they can pass on higher costs even as freight volumes weaken. Steel producers Steel Dynamics (STLD), Nucor (NUE), and Reliance Steel (RS) all report strong demand and expectations of higher pricing in 2023, as does aluminium producer Alcoa (AA).

The primary areas of weakness are companies directly exposed to consumer goods. UPS reported soft demand for packages; Packaging Corporation (PKG) and International Paper said demand for cardboard and packing related products is weak. But that appears to be offset by companies offering services that are in demand in the post-pandemic era.

This immense surge in pricing power (largely on top of price increases in line with costs last year) is great for company profits – and by extension, equities.

But the worry is the eventual passthrough to inflation, with demand for higher wages following. The risk is that the Fed ends up being on hold indefinitely or raises rates beyond the oft-mooted 5-5.25% pause point, dashing any hope of a rate cut any time soon.

Given the still-hot labour market and generally robust earnings, we can see equities drifting higher, although a sustained rally appears unlikely. Equities will also get support if the Federal Funds Rate remains below the inflation rate. As we discussed a few weeks ago, when inflation rose or the economy overheated in the past, the Fed has had to raise rates some two points higher than the inflation rate to cool things. Its current stance is remarkably dovish and decidedly unaligned with Fedspeak.

If we are correct that corporate pricing power will lead to more sticky and perhaps higher inflation, then eventually the Fed will have to be more aggressive. And that is the downside scenario for equities.

We suggest investors who are long equities remain vigilant for signs of a more hawkish Fed.

The Week Ahead

It will be another big week for earnings, with some 130 companies across our Russell 1000 universe scheduled to report. We will hear from companies across a broad mix of sectors.

Monday

• Avis Budget Group (CAR) should benefit from strong travel activity and the recent runup in used car prices.
• MGM Resorts International (MGM) and Norwegian Cruise Lines Holdings (NCLH) will report on consumer appetite for nice vacations.

Tuesday

• Advanced Micro Devices (AMD) is one of the brighter spots in the soft semiconductor space due to its cloud-based products, so its outlook may affect cloud-providers, such as Microsoft (MSFT) and Amazon (AMZN).
• Ford (F) and Cummins Engines (CMI) have invested heavily in electric vehicles and clean energy technology – will they be able to monetize this R&D in 2023?

Wednesday

• Underwear and casual clothing manufacturer HanesBrands (HBI) is in the consumer discretionary sector even though everyone needs these basics. Or maybe not?
• Kraft Heinz (KHT) will surely be trying to ride the pricing power express.
• Zillow (ZG) will likely be hurting from limited existing home listings but might salvage something from good new home demand.

Thursday

• Apple (AAPL) is the big report of the day.
• Planet Fitness (PLNT) will likely say that it is still riding a post-pandemic wave, while Peloton International (PTON) will report on its effort to remake itself after the pandemic boom.
• Royal Caribbean (RCL) provides another take on cruise demand in 2023.

Friday

• It is media day, with News Corporation (NWS), Liberty Media (LSXMK), and Warner Brothers Discovery reporting. We will get crucial data on advertisement volumes and subscriber growth, but most people will focus on what NWS says about its plans for Fox News.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)