MARKET OUTLOOK:

Many issues, including monetary and fiscal policies, corporate earnings growth prospects, and COVID-related economic dislocations are clouding the equity market outlook. One issue that strikes us as worthwhile taking seriously is inflation. 

In the United States, inflation is at an uncomfortable thirteen-year high of 5.3 per cent. We think the base effects of “cost-push” inflation factors will subside over the next 12 months, whereas “demand-pull” inflation in our assessment is likely to be more lasting.  

“Demand-pull” inflation is typically described as too much money chasing too few goods and services, which seems like an apropos description of the current environment. Household balance sheets and household wealth are remarkably strong for an economic recovery in such nascent stage, courtesy largely of government relief payments to individuals.  

At the same time, spending patterns shifted sharply towards goods last year as high touch/congregate setting services were under strict lockdown, and so demand for and prices of “things” skyrocketed. Now, with the economy reopening more broadly, demand for services is coming back online, but whereas last year there were shortages of finished durable goods, this year, there are shortages of labour -  particularly unskilled labour in service industries where labour accounts for a significant portion of total operating costs.  

With massive government income support programs very slow to wind down, low wage labourers, particularly those with young children or those with compromised health are very reticent to rejoin the workforce at the pre-pandemic prevailing wage. As a result, countries are experiencing acute wage inflation in these segments of the workforce as employers scramble to outbid one another for the marginal worker.  

This is a double-edged sword – on the one hand, workers are finally earning higher “real” (inflation adjusted) wages, and this is particularly so in the lower wage segments of the workforce where extra dollars earned are for the most part spent rather than saved, supporting economic growth. On the other hand, companies in our view will find it difficult to fully pass on the entirety of these wage increases to their own customers and their profit margins may suffer.  

The good news for corporations is they are starting from a point of nearly unprecedented strength, with worker’s share of corporate income near four-decade lows, and conversely their own profit margins at four-decade highs. Over the past 25 years, S&P 500 earnings - a good proxy for U.S. corporate profits - are up over 400 per cent while median weekly earnings for wage and salary workers are up 98 per cent.  

However, consumer prices have risen 74 per cent during the same time frame, leaving a scant 24 per cent increase in real wages over the span of an entire generation – less than 1 per cent per year. The phenomenon we are now witnessing may be the renaissance of inclusive growth, long awaited by the working poor and the long dreaded by the so-called “one-percenters”.  


TOP PICKS:

Chubb (CB NYSE) 
Last bought at $179 in October 2021
Strong pricing trends, healthy underwriting results and constructive cost management are leading to improved financial results at Chubb. On the valuation side, this issue trades at a reasonable 1.3 times book value, not excessive when compared to peers or its own trading history.

Fedex (FDX NYSE) 
Last bought at $221 in October 2021
Fedex is struggling with inflation, particularly on the wage side and their rising margins are starting to abate. We think this is temporary. Higher wages, which are likely here to stay, are gradually being offset by advances in technology. Fedex announced high single-digit price increases beginning in January. Volumes are surging, offering operating efficiencies. The cherry on top is that the market’s angst has priced the stock at its lowest valuation in memory.

United Rentals (URI NYSE) 
Last bought at $334 in October 2021
United Rentals is the largest equipment rental company in the world, positioned well for the infrastructure theme that is gaining traction in the U.S. Normalized earnings are in the US$25 per share range making this an attractive offering, even though the stock price has rebounded smartly. Profit growth is likely to be robust for the next few years.