Inflation – the Uninvited Guest

Chart of the Week

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The chart shows the year-over-year change in the Consumer Price Index in the United States, i.e. inflation. A distinction is made between the headline figure (headline, red), which includes all goods, and the core figure (core, blue), which excludes food and oil prices, as these are often highly volatile.

Why this matters:

Most market participants assume that the high inflation readings of 5% were only caused by a base effect following the pandemic and would quickly fall back to 2%. Central banks have also reassured investors using the same arguments. However, signs are now increasing that this may not be the case. The level of inflation has a major impact on central bank policy and the financial markets. On October 13, the inflation figure for September will be published. If the figure comes in above 4%, this could have a very negative impact on both equities and bond markets.

Inflation – the Uninvited Guest Who Came for a Short Visit but Now Wants to Stay Longer

Inflation can rise for the following three reasons:

• Demand-pull inflation
• Cost-push inflation
• Expected inflation

Demand-pull inflation

Due to very strong demand, delivery times become longer. Customers who urgently need goods or intermediate products for the production of other goods are willing to pay more. Suppliers then raise their prices.

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The chart shows data from a survey of purchasing managers in the United States. The survey is often a leading indicator of the future development of companies. Let us first focus on the supplier delivery times line (green). After an initial shock following the Covid crisis, delivery times declined again and everyone thought the problem had been resolved. However, delivery times have now increased sharply once more. This is likely to have a very negative impact on the holiday season for most companies.

New orders have declined but remain at high levels, while supply chain disruptions continue to persist. Further high inflation readings from this area are therefore very likely.

Cost-push inflation

Due to the pandemic, nearly all global supply chains have been thrown completely off balance. Whenever it seems that supply chains are starting to normalize again, a new bottleneck emerges somewhere — container congestion in Asia, the blockage of the Suez Canal, shipping backlogs at U.S. ports, power outages in China, and more.

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The chart shows shipping transportation costs since 2005. These costs continue to rise sharply. A clear signal that supply chains remain severely disrupted and will still need time to return to normal.

One positive aspect worth mentioning is that the prices of many commodities have declined by 10–30% since mid-year. However, it is currently difficult to assess whether this will be enough to offset the increase in transportation costs.

The chart above, viewed from the perspective of demand-pull inflation, also shows that input prices (orange line) remain very high and are not declining. Cost pressures persist and are unlikely to cause inflation to ease significantly anytime soon.

Expected inflation

This is the most difficult inflation driver to analyze. It is largely about the psychological behavior of the population. As long as people believe that high inflation will only last for one or two months, workers are unlikely to demand higher wages. However, if expectations begin to change, employees may start demanding wage increases, which in turn fuels inflation even further. A spiral can begin that is difficult to stop: higher inflation leads to higher inflation expectations, which then lead to even higher inflation, and so on.

Conclusion:

Two of the three inflation drivers remain strong and are showing little sign of easing. We therefore expect inflation figures to come in higher than generally anticipated. If inflation does not decline as expected, this could trigger the third inflation driver — expected inflation — setting off a spiral that may be difficult to stop.

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Outlook on Corporate Earnings Reports for the Third Quarter of 2021

Starting next week, the first companies will begin reporting their third-quarter earnings. What should investors pay attention to?

For analysts, it is usually very damaging to their reputation if their earnings estimates for a company differ too significantly from the reported results — especially when their forecasts are far too optimistic. For this reason, most analysts revisit their models two to three weeks before the start of earnings season and adjust their estimates accordingly.

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The chart shows the Citibank Earnings Revision Index. It currently indicates that many analysts have significantly lowered their earnings estimates in recent weeks. This was one of the reasons behind the risk-off phase described in the previous weekly report. This suggests that major negative earnings surprises are likely to be avoided.

One way to assess whether companies are overvalued or undervalued is to compare the earnings yield with the yield on 10-year government bonds. The earnings yield is calculated by dividing a company’s earnings per share by its stock price. The chart shows that most companies are currently valued slightly higher than the long-term average, but are still far from being overvalued.

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Based on the two factors described above, a relatively calm earnings season can therefore be expected.

During the release of second-quarter 2021 earnings, nearly 50% of companies complained about rising costs. It will be important to observe whether more or fewer companies see the same issue for the coming quarter. This represents the biggest risk during the upcoming earnings season. If too many companies warn of new challenges ahead, stock prices could face downward corrections.

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