Companies are warning about supply chain problems and inflation. Here’s what it could mean for stocks

Published Thu, Sep 9 20211:16 PM EDTUpdated Thu, Sep 9 20214:00 PM EDT

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

With supply chains under pressure, companies are warning ahead of third-quarter earnings that shortages and inflation could affect their results and linger for a while. Companies like PPG Industries and Sherwin-Williams alerted investors this week about lower-than- anticipated third-quarter revenues, rising costs and supply chain problems. But analysts say these red flags for corporate profits are not yet a concern for the broader stock market. Some of them are seen as temporary, and many of them can be alleviated as companies pass on costs to customers. Even so, analysts warn it's a trend to watch for the longer term. "I keep saying, as early as the third-quarter earnings season, the earnings themselves will be good, but I think you're going to start seeing corporate executives give greater insight into the end of the year and early next year, and I think it might be less rosy than expected," said Michael Arone, chief investment strategist at State Street Global Advisors U.S. SPDR Business. Profits driving stocks Stunning profit growth has been a catalyst for the market's gains, taking the S & P 500 to new highs this year. Earnings are expected to grow by 15.8% in the third quarter, according to Refinitiv. The second-quarter earnings gain of 95.6% is expected to be a peak in profit growth. The gain is outsized in part due to the large decline in profits when the economy shut down in the year-earlier period. Refinitiv said earnings were 15.8% above expectations, the highest profit growth since the fourth quarter of 2009. Companies also beat estimates by a pace of 87.7%, versus the average 66% rate. Analysts don't expect earnings themselves to trip up the stock market in the near term, but there could be some volatility if companies begin warning investors about future quarters. "If you look at the performance so far this year, the market is overwhelmingly driven by earnings growth," Arone said. "During the summer growth scare, investors have been able to ignore all kinds of things that could derail the bull market. They've been able to do that because the margins have been phenomenal." "It's interesting. I think the irony here is the market's greatest strength could also be its greatest risk, as we pivot to next year," Arone said. "We have been in this incredible year where analysts have struggled to keep up with earnings growth. That's all going to change as we pivot from 2021into 2022." The third-quarter reporting season is still several weeks away and gets into full swing in mid-October. For now, companies have a window in which they can announce unexpected changes that will affect their reports. "We have great earnings recovery. That's all good. Strong earnings for the next couple of years is what we're forecasting," said Savita Subramanian, head of U.S. equity strategy and quantitative strategy at Bank of America. But she said there are some warnings for the market in the early comments. "This is sort of the beginning … of little misfires here and there in the market, and some of those early cycle stocks like home builders and consumer cyclicals are starting to show signs of distress. I think it's something to watch," Subramanian said. She said inflation risks are beginning to "eke into margins." PPG warned Tuesday that sales volumes in the third quarter will be lower than what it previously expected by $225 million to $275 million . It said the volumes are being negatively affected by increasing disruptions in commodities supplies, shortages and logistics challenges. The company also said raw material inflation is higher than expected, by $60 million to $70 million in the quarter. Rival paint maker Sherwin-Williams echoed those comments , as it lowered guidance for third-quarter net sales. It also said disruptions from Hurricane Ida are making supply issues more complicated. Home builder PulteGroup said Wednesday supply chain issues worsened in the second half of the year and are affecting its building schedule. "If you look at earnings revisions, they're very positive and analysts are still marking up expectations," Subramanian said. "If you look at management guidance, management guidance has actually dropped." "We're having more and more companies warning around the next couple of quarters and supply chain risks, just basically disruption to supply chains and inflationary pressure," she added. "Wage inflation or input costs are starting to impinge on margins." Market risk via tapering? Ironsides Macroeconomics managing partner Barry Knapp has been expecting a near-term pullback in the market, but he said the pressure on earnings from rising prices is not going to be the issue. Companies can pass along the increases, and they should be temporary. Corporate profits may instead be helped by the streamlining and productivity gains companies realized during the pandemic, he said. The impact of the Covid delta variant on companies this summer and fall may have made this trend even more pronounced, as companies continued to focus on work from home and other trends, he said. "The earnings situation is great. it's a positive ... but then we're trading at 21, 22 times earnings. it doesn't leave us a lot of wiggle room. But I think the earnings growth is going to be stronger than it was in the last business cycle," Knapp said. General Electric said Wednesday it expects issues into 2022. In a shareholder update on its website that worldwide material and labor availability are under pressure in several areas, particularly semiconductors, resins and logistics. "We are experiencing sustained pressure in our health-care business in 3Q, which we expect to continue through the second half of the year, negatively impacting revenue and margin growth," GE vice president of investor relations Steven Winoker wrote. "Although we expect a challenging environment through the first half of 2022, we are working with our partners, suppliers, and logistics channels to alleviate the impact and help mitigate output and cost challenges," he noted. "We're committed to our full year guidance of low-to-mid single-digit revenue growth in health care, with greater than 100 bps of organic margin expansion." Inflation temporary or not? The Federal Reserve has said the rise in inflation is temporary, but some strategists expect rising prices to be more persistent than the central bank expects. If that's the case, inflation could ultimately be an issue for earnings. Inflation was evident in the sharp 4.3% rise in hourly wages in the August employment report on a year-over-year basis . Inflation has also been showing up in rising producer prices and in elevated consumer price index readings, rising 5.4% in July from the prior year . On Wednesday, Subramanian updated her outlook for stocks this year, and now has an S & P 500 target of 4,250 for 2021 and 4,600 for 2022. Her prior target for this year was 3,800 for this year. The average year-end target of the top strategists surveyed by CNBC is 4,421. The reasons behind her bearish view are euphoric sentiment, high valuations and the fact the market's gains are being led by a narrow group of big tech growth stocks. But she's also watching out for inflation, and she recommends buying stocks that benefit from the trend. "There's a lot of inflation beneficiaries within small caps. Small caps are more domestic. They are more tethered to U.S.GDP and less global," she said. Subramanian added that there could be more bargains among stocks in the Russell 2000 than the S & P 500. Within large cap, she prefers dividend growth stocks in energy, financials and materials. She said she favors "companies that are growing their earnings, participating in some of the inflation risks and meeting yield requirement in a still very low yield world," she said. The small-cap Russell 2000 was up 0.8% on Thursday, after falling 1.1% Wednesday. The S & P 500 was flat Thursday after slipping 0.1% on Wednesday.

Traders works at the New York Stock Exchange (NYSE) August 3, 2021.

Andrew Kelly | Reuters

With supply chains under pressure, companies are warning ahead of third-quarter earnings that shortages and inflation could affect their results and linger for a while.