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A Challenging Developing Storyline

CAMS Weekly View from the Corner – Week ending 12/10/21

December 13, 2021

Weakening Productivity Plus Rising Unit Labor Costs Equals Challenging Company Profit Margins

A month ago we shared within an edition various measures of employment and price inflation that was released in one morning.  The gist of the piece was our on-going observation that the Federal Reserve’s steadfast view that price inflation was going to be a blip on the timeline (think “transitory”) was incorrect and this was proving to be the case with each passing month. We concluded with the view that it would not be a surprise if said price inflation measures would go from posting a three-plus decade high to a four decade high.  Friday’s price inflation data born that out as we are now dating back to the very early 1980’s for similar inflation experiences.  This is well covered and price inflation is the focus of the citizenry at large so we trust you dear reader are aware of the newly released numbers so we will steer clear of Friday’s inflation data.  Friday’s release does elicit a larger storyline that we in-part delved into in our most recent edition. Is Stock Price Volatility Omicron Only? The newfound price volatility in the stock market was easily attributed to only the new Covid variant which from our perspective missed (and perhaps continues to miss) the simultaneous large (if not larger story for markets) of non-transitory price inflation causing world monetary bodies to shut off the money printing spigots quickly. This has bled into Chairman Powell and his cohorts at the Fed to back pedal on “transitory” in that they have retired the phrase while simultaneously offering that the money printing spigot will be turned off quicker than previously offered. This also brings a follow-on expectation that they and other monetary authorities around the world will have to increase interest rates sooner than previously offered.  All told, this speaks to financial conditions getting tighter when employing a forward looking view.  Importantly, when it comes to collective market participants a forward looking view is all they care about.  “Today” is only important relative to its impact on a continued and on-going forward looking view down the economic timeline. Tighter Financial Conditions Plus Highly Valued Markets Equal? Tighter financial conditions coming for a stock market in particular that has been bid up to the sky (when viewed through historical valuation studies) on the back of ultra-easy financial conditions such as zero interest rate policies and global printing presses running full-tilt offers a market landscape of expected volatility and perhaps, dare we even think this in our analysis, corrective pricing action. As we apply rational forward looking thinking can we believe that monetary authorities around the world that are presiding over multi-decade high price inflation levels resulting from massive money printing on their part and massive fiscal stimulus on the part of various global governments will be able to deal with said inflation by tightening financial conditions while simultaneously perfectly balancing various markets that are at historically elevated valuation levels without said markets even posing a hiccup?   Rationally speaking, that is a tall order.  At a minimum, volatility (think up, down, all around) seems fair to expect.  At worse, downside price action resulting from said authorities being unable to navigate the above described economic/market tight rope perfectly.  None of said entities have a history of successfully walking said tight rope perfectly just for a generalized reality check. To Our Logical Header Formula We have sprinkled within a number of editions in 2021 that price inflation makes society poorer.  Ultimately, this includes individual businesses.  Keep in mind stock markets are share listings of businesses.  With this, they too are subjected to all the market/societal forces that any business incurs. We have offered the concept of “passing-through” cost increases to end consumers as a primary way for businesses to maintain their profitability – think maintain their profit margins.  We have also shared in previous editions how laborers have become their own pseudo Labor Unions in that they are “striking” by leaving for better employment terms en masse via the Quit Rate.  In addition, as all of us wear our consumer hats, we can balk at X-number of price increases by slowing our consumption or moving to a competitor’s product.  All of this results in businesses being pressed against a very challenging backdrop of how to maintain their profit margins while navigating the above and other general societal/economic storylines. Importantly, it is profit margins that are the lifeblood of net profits for any company and it is net profits that are ultimately the lifeblood of company stock prices. 

The above chart is a four decade look at what is known as Unit Labor Costs.  Per the chart we can see businesses are experiencing multi-decade highs with their unit labor costs.  Very simply, when analyzing a business (or businesses in the case of a stock market) you can get a sense of the degree they will be having pressure on their profit margins by viewing the pressure (upward or downward) they are experiencing with their unit labor costs.  Similar to us as consumers experiencing lower “profit margins” via our wages being ate up by the increased prices we pay businesses are experiencing increased pressures on their profit margins in light of their unit labor costs increasing tremendously to the upside.  Coming tightening financial conditions along with expected challenges to the ultimate lifeblood of stock prices (net profits) being negatively impacted via multi-decade high levels of unit labor costs suggests a backdrop where stock market pricing will be experiencing more volatility.  Downside corrective action is not out of the question. For our part we are participating in markets with even stricter buy side disciplines and weightings while adhering to our disciplined selling rules.  In our view, with a forward view in mind, now is not the time to be lackadaisically thinking the money printing operation has the markets covered as said money printing is expected to end sooner than even suggested previously by the Federal Reserve.  I wish you well…

Ken Reinhart

Director, Market Research & Portfolio Analysis

Footnote:

H&UP’s is a quick summation of a rating system for SPX9 (abbreviation encompassing 9 Sectors of the S&P 500 with 107 sub-groups within those 9 sectors) that quickly references the percentage that is deemed healthy and higher (H&UP). This comes from the proprietary “V-NN” ranking system that is composed of 4 ratings which are “V-H-N-or NN”. A “V” or an “H” is a positive or constructive rank for said sector or sub-group within the sectors.

This commentary is presented only to provide perspectives on investment strategies and opportunities. The material contains opinions of the author, which are subject to markets change without notice. Statements concerning financial market trends are based on current market conditions which fluctuate. References to specific securities and issuers are for descriptive purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. There is no guarantee that any investment strategy will work under all market conditions. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. PERFORMANCE IS NOT GUARANTEED AND LOSSES CAN OCCUR WITH ANY INVESTMENT STRATEGY.

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