As we continue to process the deluge of information being reported by companies in their first quarter earnings announcements, we seek to get a read-through on our portfolio companies and the broader economy. One theme that has been popping up across the board is that of inflation. Inflation has been a worry for the market for some time. It is now here.
Below are some snippets from recent results, giving colour on these inflationary forces.
“We’re seeing substantial inflation. We’re raising prices, people are raising prices to us. And it’s being accepted. We really do a lot of housing. The costs are just up, up, up…It’s an economy – really, it’s red hot. And we weren’t expecting it” – Berkshire Hathaway (BRK) CEO Warren Buffett
“We’re clearly seeing some price pressure, not unlike what you’ve heard about elsewhere, resins, certain metals.” – General Electric (GE) CEO Larry Culp
“I would tell you the inflationary pressure people see and the headlines that they have on it and all our competitors are feeling is unlike anything I’ve seen because it’s just not in commodities. It’s sort of across the board. And better stated, it’s just not raw copper, steel and aluminum. It’s across the board because everyone sort of has what I would call a COVID surcharge of inefficiencies that they’re trying to pass on.” – Lennox (LII) CEO Todd Bluedorn
The reason inflation is a worry to the market in general, is for two reasons: (i) inflation can negatively impact the margins of a business if they are unable to pass on their cost inflation to consumers via higher prices; and (ii) the worry that persistent high inflation will force the Federal Reserve to raise rates, which would effectively punish long-duration assets such as equities (particularly growth stocks) via the discounting mechanism.
We are already beginning to see the impacts of inflation hit the profit and loss statements of companies. Take iRobot (IRBT) for example. They make the Roomba robotic vacuum cleaners. They had a 1Q21 earnings result that handily surpassed expectations. The company was able to raise its revenue guidance for FY21 from what it had signalled just one quarter ago. However, the company also lowered its gross margin guidance for FY21, and materially so. IRBT cut its gross margin guidance by around 2 percentage points to around 39% at the midpoint. The company cited cost pressures across resin as well as chips.
The pandemic has upended supply chains and they have been unprepared for this enormous influx of demand, driven by economies reopening and a healthy consumer. IRBT management on the call gave the following comments: “From a profitability perspective, the semiconductor chip shortage is resulting in higher costs for these components. At the same time, we are now grappling with rising costs for raw materials, air freight and transportation. While these transitory costs are likely to remain elevated for the next several quarters, we expect that over time they will revert to more normalized levels as market forces adjust.”
Broadly speaking the market expectation is for there to be inflation, but for it to be temporary. This makes sense, as more supply should be able to come online and relieve the supply chain bottlenecks that are causing price spikes. However, what is unclear is the extent to which inflation will overshoot the Federal Reserve’s 2% average inflation target over the long run, and for how long. If the inflation rate materially exceeds expectations and stays elevated for longer than anticipated, then this will erode confidence in the Fed’s grip on inflation and fuel worries that rates will need to be hiked to reign in inflation. Equity markets would likely front-run this, anticipating rising rates and selling off stocks.
While this is a possibility, it’s in no way a certainty or a prediction. No one knows what the future will hold in terms of the macroenvironment, but it is worth turning our minds to some of the broader forces in the economy such as inflation, and how they might affect the companies we are invested in.