INSIDE THIS EDITION:
In the US, the big surprise for many investors has been the resiliency shown in earnings reports for the third quarter. Both earnings and revenues generally exceeded expectations, with the S&P 500 posting its third-highest earnings per share growth rate in over a decade. This has been a boon to investors as domestic equities have continued moving higher. Not even the Fed’s announcement of tapering earlier this month was able to push investors off their bullish positioning.
CFTC S&P 500 Speculative Net Positioning
However, investors should pay close attention to the risks of a more inflationary environment, especially as it relates to corporate earnings moving into 2022. A couple of weeks ago in our weekly report, we discussed inflation readings and how the last CPI data release showed consumer prices up by 6.2% for the month of October while PPI data showed producer prices up 8.6% for October.
With inflation running hot, it is no wonder that many S&P 500 companies mentioned inflation in their earnings call for the third quarter. As the chart below shows, 285 of the 500 companies that comprise the S&P mentioned inflation. This represents an increase over the second quarter and the highest number of mentions in the last five years. In fact, in the previous five years, the average number of mentions of inflation during conference calls has been only 137. And although we are firmly into the fourth quarter, we still have more than 40 S&P 500 companies that are yet to report their third-quarter results which means the number of inflation mentions is likely to increase.
Factset also drilled deeper on inflation mentions during third-quarter earnings calls and did a sector-based analysis. Interestingly, across the board, each sector saw an increase in inflation mentions during third-quarter earnings calls with one exception, the consumer staples sector. The consumer staples sector bucked the trend, decreasing from 28 mentions of inflation in the second quarter to only 22 mentions during the third-quarter earnings calls. At 22 mentions, it still represents 88% of companies from that sector, citing inflation on their third-quarter earnings calls and indicating that companies are worried about it.
This brings us back to the topic of possible margin compression over the coming quarters. With costs clearly on the rise for producers, we think investors should be watching whether those costs can be passed along comfortably to consumers. For now, it has not caused a significant issue. However, it would not surprise us if we started to see a more meaningful impact on margins.
As of now, consensus profit margin expectations for the fourth quarter are just under 12%, a little bit more than 100 basis points below what was reported for the third quarter. With a rise in energy costs and increasing wage pressures on the lower end of the wage spectrum, we think investors need to be prepared for narrower-than-expected margins.
This is especially true as we see risk-on sentiment dominate equity markets as of late. As the chart that follows shows, the Fear & Greed Index, which measures investor sentiment, shows that extreme greed permeates the equity market.
While we don’t believe that the bull market will end today, we think investors need to pay closer attention to objective data on sentiment and expectations. When sentiment and expectations diverge, we see increased volatility, especially further along the business cycle.