Rising inflation has always been a major headwind for US stocks, Other studies have suggested that some sectors cope fine with moderate inflation, as they are able to pass on price rises – but above 4% or so, turbulence kicks in. Now that America’s “labour market is showing a bit of heat”, as The Wall Street Journal’s Justin Lahart puts it, a wage-price spiral is a possibility, forcing the US Federal Reserve to raise interest rates faster than expected and giving equities a nasty shock.
But the labour market’s new-found strength could play out another way, reckons Lahart. Companies can absorb their higher labour costs rather than pass them on. And plenty could opt to do just that. “Inflation has been so low for so long, consumers have become conditioned to it, making it hard for companies to raise prices without losing customers.” Competition has become “unusually intense” now that the likes of Amazon are breaking into new markets. But absorbing labour costs means historically high margins will fall, undermining profit growth and hence the equity rally.
It hardly helps that profit growth has been strong recently, so expectations are high. The companies comprising the S&P 500 index are estimated to have increased earnings-per-share by around 15% (not all of the results have been released yet). That would be the strongest figure in six years. On the profit front, then, there is nowhere to go but down, which is especially bad news for a chronically overvalued equity market.
The economy, meanwhile, is strong enough for interest rates to keep rising gradually. The combination of slowing profits yet rising rates, concludes Lahart, is “not exactly the stuff of investor dreams”.