Strong Economy & Strong Earnings -- Does Inflation Follow?

Real gross domestic product—the sum of all goods and services produced in America adjusted for inflation—grew by an annualized rate of 6.4% in the first quarter of the year as the government distributed trillions of dollars in Covid-19 stimulus and consumers stepped up spending. Indeed, wages and consumer spending are both above pre-Covid levels. Meanwhile, the Fed announced it will keep short-term interest rates close to zero for quite some time and will continue to buy back $120 billion of bonds each month. From the President, a new Families Plan was proposed that includes $1 trillion in new spending and $800 billion in tax credits. That is on top of the recently proposed $2.3 trillion Infrastructure Plan and the $1.9 trillion Covid Relief bill that was already signed.

The nationwide rollout of Covid vaccines, the persistence of ultralow interest rates, and expectations for continued strong economic growth fueled by explosive government spending have kept the bull market in stocks moving higher. Most importantly, earnings are surging. With over 60% of the S&P 500 companies reporting first quarter results, sales have risen 11% and earnings are up 51% from last year’s depressed levels. The earnings are 23% above estimates with every sector showing positive surprises. The proportion of S&P 500 companies beating earnings estimates hit a new record. Meanwhile competition from other asset classes has declined as Treasury bill yields are moving deeper into negative territory and corporate bond yield spreads are very low.

A lot of this good news is priced into the market as valuation levels remain near all-time highs. So far this year, earnings growth is winning the tug-of-war over declining valuations.

Valuations will decline if inflation rises. While the Consumer Price Index (CPI) is not yet showing troublesome inflation, nearly 60% of commodities have risen over 50% in the past year, with lumber prices up an astonishing 369%. Mentions of “inflation” on company earnings calls have more than tripled this year.

The massive government stimulus has brought debt levels above total GDP, a harbinger for slower future growth, while the unprecedented increase in money supply will ultimately be inflationary.

In a potential stagflationary environment, those companies which can generate free cash flow above the rate of inflation and those which have pricing power (i.e. can raise prices without impacting demand) will do well.

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