Fed has a sunny view on inflation as companies see the clouds

(Bloomberg) — The Federal Reserve may be downplaying the risk of continued inflation, but those with arguably the best vantage point — the companies themselves — have a less optimistic view of rising prices.

Last week, Conagra Brands Inc. and PepsiCo Inc. already indicated that higher input costs will be more than a drop. Instead, they expect everything from raw materials to labor to remain significantly more expensive in the coming months.

“I don’t assume it will be transient,” PepsiCo Chief Financial Officer Hugh Johnston in an interview on Bloomberg TV on July 13. “It will be with us for most of next year.”

If these predictions are correct, equity investors will eventually have to reckon with an ongoing inflationary environment. They have been complacent thus far, contributing to a rally in technology stocks and other higher-value groups that thrive when government bond yields fall. But that could change quickly if inflation remains high and yields rise, according to Michael Darda, chief economist and market strategist at MKM in Stamford, Connecticut.

“We see risk building in these sectors that would be vulnerable to a reversal in real interest rates or a rise in inflation expectations,” he wrote in a research note on July 14.

Soothing markets

Fed Chair Jerome Powell’s reassurance that rising costs will remain manageable helped calm markets last week, especially after a July 13 report showed the consumer price index rose the most since 2008.

The yield on 10-year Treasuries fell from around 1.42% on July 13 to below 1.30% on July 16. The S&P 500 index fell 1% but remained within the range of the record high reached earlier this month. And mega-cap technology stocks like Apple Inc. and Microsoft Corp. expanded their recent rallies, despite the broader decline in equities.

Meanwhile, inflation and companies’ ability to pass costs on to customers is one of the biggest themes of this earnings season. The word inflation was mentioned in 87% of earnings conference calls by S&P 500 companies tracked by Bloomberg this month, compared to 33% in the same period a year ago.

During Conagra’s July 13 call, inflation was mentioned 49 times. The maker of Vlasic pickles and Slim Jim snacks saw its shares fall after it cut its earnings forecast for the current fiscal year as it expects higher input costs to weigh on margins. Two analysts downgraded the stock, which fell 3.5%, the largest weekly decline in a month.

PepsiCo outperformed as investors welcomed the earnings and revenue growth forecasts despite inflation warnings. Johnston, the company’s CFO, said customers are willing to pay more for its products, which helps offset higher input costs. The stock rose 4.2% for its best week since March, closing on a record Friday.

Banks are okay

Of course, there are plenty of executives who find the fear of runaway inflation exaggerated. During JPMorgan Chase & Co.’s earnings call. Last week, Chief Executive Officer Jamie Dimon told analysts that inflation may be worse than the Fed expects, but “it won’t make any difference” if jobs are plentiful and growth remains strong. Meanwhile, David Solomon, head of the Goldman Sachs Group, said he expects inflationary pressures to be transient and that “the resulting risks can be adequately managed.” The KBW Bank Index fell 2.4% on a weekly basis, the largest drop in a month.

That said, these more optimistic views are not particularly surprising given that financial firms are expected to do well when inflation peaks.

“Some degree of inflation is absolutely absorbable and possibly, as far as there are higher interest rates, would be positive” for banks, said JMP Securities analyst Devin Ryan.

The ability to counter the effects of inflation is likely to be a top priority for investors this week when Chipotle Mexican Grill Inc. and Coca-Cola Co. report profits.

“The economy was very strong in the second quarter, so I expect most companies will be able to beat on the bottom line, if not the top line too,” said Bill Stone, chief investment officer at Glenview Trust Co. . it’s about whether they can pass on price increases.”

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