Investing In A World Where Inflation Makes A Comeback
As it was widely expected to do, the Federal Open Market Committee decided unanimously on Wednesday to raise the target range for the federal funds rate by one quarter of a percentage point to 2% to 2.5%
The FOMC also removed a sentence from its statement that had said monetary policy remains “accommodative,” although Chairman Jerome Powell said in his post-meeting press conference that this does not mean that the Fed will not respond to negative economic developments.
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“In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2% inflation objective,” says the statement. “This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”
In the immediate aftermath of the Fed’s move, the yield curve grew flatter as short-term rates rose while longer-term rates did not move or fell slightly. Although short-term rates remain below long-term rates, an inverted yield curve in which the opposite is true has historically been highly correlated with subsequent economic downturns.
The Federal Reserve operates under a dual mandate that compels the central bank to achieve full employment and price stability. At 3.9%, unemployment is arguably at a rate that in the past has marked “full” employment, and prices of goods, labor, and assets are rising across the board. Over the past decade, the Fed has fought to keep prices from deflating, but now Powell is presiding over a central bank that is keeping an eye out for signs that inflation is running too hot.
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Investing In A World With Rising Prices And Wages
Stocks have a mixed record during periods of high inflation, but it stands to reason that if prices a company is paid for its goods or services are rising faster than the costs of production, the business becomes more valuable. So far, so good this time around, but higher labor costs are in danger of tipping the balance. A research note this week from UBS shows that pricing over the last three months for companies in the S&P 500 grew 3.3% from one year ago, 2.3% excluding the energy sector. Wage growth for the S&P 500, excluding energy, is running at 2.4% a year, but down from highs earlier this year above 3%. UBS says that corporate profit cycles have historically turned lower once annual wage growth tops 4%.
Wage and price growth varies widely across industries. UBS finds that energy, utilities, and materials enjoy the strongest profit margin tailwinds, thanks to pricing growth of 6% to 20%. Transportation stocks saw wage growth slow by two percentage point in the most recent quarter. If inflation persists or accelerates, it will be helpful to monitor these metrics.
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Stocks With Pricing Power
To find companies with strong pricing that could outperform the market, UBS searched the S&P 500 for stocks that rank in the top third for price growth and those in the top third ranked by three-month change in price growth, and then selected only those stocks on which the firm has a buy rating. Among those that make the cut are big banks like JPMorgan Chase & Co. (JPM), Citigroup (C), Wells Fargo & Co. (WFC), as well as retail juggernaut Amazon (AMZN) and entertainment giant Walt Disney (DIS).
Just as important as pricing power, is a demonstrated history of dividend growth that keeps shareholders ahead of inflation. That wasn’t much of a hurdle in the past decade when inflation was at negligible rates, but now running at 3% per year, inflation should be a on your radar when you decide what to do with your money.
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