Inflation – feared by investors – is showing in earnings. Here’s why it can be good news

Published Thu, Apr 29 202111:40 AM EDTUpdated Thu, Apr 29 202112:20 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Key Points

First-quarter earnings are rocketing, with gains double what was expected. One reason is that companies have pricing power to combat higher costs.
Inflation is showing up across different sectors and is coming broadly from raw materials costs, higher transportation rates and supply chain disruptions.
There are winners and losers from inflation, but the question is will it be a temporary or long term impact.

Corporate profit growth so far is double what was expected in the first quarter, and one added boost for some companies may be the inflation that so many investors had feared. Companies from Dow Inc to Harley-Davidson are reporting rising costs, but they also sold goods at higher prices in the first quarter. In many cases, that resulted in higher margins and profits. "Obviously, there are going to be winners and losers, companies or sectors, that have historically been impacted or are more labor intensive like consumer discretionary. Those could be losers," Bank of America equity strategist Ohsung Kwon said. Strategists have expected many companies to see net margins — the amount of profit generated as a percentage of revenue — expand because of firms' cost cutting and productivity changes during the pandemic. Inflationary pressures have also been leading companies to raise prices. That can be a positive if costs are covered, but a negative if they aren't. "I think it's a double-edged sword here," Fundstrat head of global portfolio strategy Brian Rauscher said. "Some are going to have these transitory input cost pressures. The supply chains around the world haven't gotten fully back online yet. "Until we get the global machine up and running like it was pre-Covid, we're going to have bottlenecks," he added. "In the short term, that's a headwind for margins. The other side is companies during Covid have streamlined their operations. They've increased their operating margins." Rauscher said if the rising input costs are temporary, it should not be a problem for margins. "What's going to happen is revenues are going to start accelerating for these guys and that's what we are going to focus on," he said. One big disruption is the semiconductor shortage, which is showing up in the auto industry and technology. Even Apple is impacted by the shortage, which is showing up as revenue lost from iPad and Mac sales. Apple said on Wednesday that it expected its fiscal third-quarter sales to be about $3 billion to $4 billion less than it could be if it didn't have supply issues. Margin pressures Bank of America says net margins for the S & P 500 are expected to decline by 20 basis points to 11.1% in the first quarter, possibly due to cost pressures. But for the year, the bank expects S & P 500 net margins to increase to 12.5%. That's above the Wall Street consensus of 12.1%. That is a strong gain, compared to net margin of 10.8% in 2020 and even 11.9% in 2019. Kwon said margins were even higher at 12.4% in 2018 before being affected by the trade wars in 2019. "There's good inflation and bad inflation," he said. "So far, it looks like it's been pretty good inflation. Companies have pricing power." "That could potentially reverse," Kwon added. "Heading into 2022, we think the divergences between the winners and losers are likely to widen. The companies that have pricing power are better off." For now, earnings are rocketing, fueled by strengthening demand in the reopening economy and a comparison to last year's weakness. CFRA chief investment strategist Sam Stovall said first-quarter earnings growth so far is at 29.1%, double what was forecast. The second quarter is expected to see profit growth greater than 50%. "If share prices are being driven by the possibility that second-half earnings growth is even stronger than anticipated, the worry is we may be underestimating the growth in inflation," he said. Stovall said inflation is largely a positive thus far, allowing companies to boost prices. He added that the level of inflation is not expected to get too great before it recedes. When inflation takes a turn for the worse Yet, the concern is that inflation could be hotter and not as temporary as economists — and the Federal Reserve — expect. When inflation goes bad, companies are unable to pass along rising costs, and margins erode. "We highlighted the number of mentions, companies made of the word 'inflation' during earnings calls," Bank of America's Kwon said. "It quadrupled from last year. It correlates to [the consumer price index] and that points to a pretty robust uptick in CPI." During 3M's earnings call, CFO Monish Patolawala said: "The inflation is coming in faster." He said the company is working with suppliers to minimize disruptions, and it's raising prices. 3M was able to make gains in operating margins through organic volume growth and by cost management and productivity efforts. "These actions will take a little time to gain traction," Patolawala said. "Therefore, we anticipate a second-quarter year-on-year operating margin headwind of 75 to 125 basis points from selling prices, net of high raw materials and logistics costs." Winners and losers as inflation rises Kwon said energy and materials are the sectors that do best in inflationary periods. Companies like Mosaic , Occidental Petroleum , Halliburton , and Exxon Mobil are potential winners, according to Bank of America. There are also tech companies on the list, including Micron Technology , Advanced Micro Devices and Oracle. The firm also has a list of companies that are more negatively affected by inflation, including Hershey and Campbell Soup, as well as retailers like Amazon and Costco . Kwon said Bank of America strategists expect to see margin pressure in the consumer discretionary sector due to rising labor costs. The bank cited this as one reason for its downgrade Thursday of consumer discretionary stocks to underweight. Bank of America analysts expect consumer discretionary margins to have recovered from 5.3% in 2020 to 6.5% this year and to 7.3% by 2022. However, that is below the Wall Street consensus for 2022 net margin for the sector of 7.9%. Restaurants are also part of the consumer discretionary sector. Chipotle Mexican Grill CFO John Hartung talked about the impact of higher labor costs on the company's earnings conference call. Hartung said that if wages were to increase by 10%, that would impact margins by 140 to 200 basis points. In order to offset that with menu pricing, the company would have to raise prices by 2% to 3%. "So, all of that is very, very manageable and we feel like if there is going to be significant increased inflation because of market-driven or because of federal minimum wage, we think everybody in the restaurant industry is going to have to pass those costs along to the customer," he said. Become a smarter investor with CNBC Pro . Get stock picks, analyst calls, exclusive interviews and access to CNBC TV. Sign up to start a free trial today .

Shipping containers are unloaded from ships at a container terminal at the Port of Long Beach-Port of Los Angeles complex, amid the coronavirus disease (COVID-19) pandemic, in Los Angeles, California, April 7, 2021.

Lucy Nicholson | Reuters

Corporate profit growth so far is double what was expected in the first quarter, and one added boost for some companies may be the inflation that so many investors had feared.

Companies from Dow Inc to Harley-Davidson are reporting rising costs, but they also sold goods at higher prices in the first quarter. In many cases, that resulted in higher margins and profits.

"Obviously, there are going to be winners and losers, companies or sectors, that have historically been impacted or are more labor intensive like consumer discretionary. Those could be losers," Bank of America equity strategist Ohsung Kwon said.

Strategists have expected many companies to see net margins — the amount of profit generated as a percentage of revenue — expand because of firms' cost cutting and productivity changes during the pandemic.

Inflationary pressures have also been leading companies to raise prices. That can be a positive if costs are covered, but a negative if they aren't.