Demand Destruction

By David Nelson, CFA CMT

On the heels of a dovish Fed meeting and strong employment report the S&P finished the week up better than 2%. Even more compelling, Friday marked the seventh straight session stocks ended the day at a closing all-time high. Is there anything that can stop this train and maybe more important is it too late to jump on board?

Data by FactSet 

No question this is an earnings driven rally. The only thing that has gone up faster than stocks is the bottom line. At the start of the year 12-month forward earnings for the S&P stood at $165. Today a little more than 10 months later consensus is close to $217 up 31%. All the more impressive in the face of COVID challenges and supply chains that are only beginning to repair.

The September swoon was more than made up in October. With another strong earnings season in the books stocks pushed higher looking beyond some of the obvious headwinds. Line items in the income statement getting the most attention are wage and inventory costs along with increased prices for delivery.

Corporate Margins

One bright spot is that shipping container costs have fallen 22% in China since September. However, many challenges still remain. Labor costs continue to climb in the face of a surging demand for workers. Friday’s employment report was strong with non-farm payrolls coming in at 531k and unemployment at just 4.6%. Impressive numbers but likely unsustainable unless the participation rate starts to rebound. Add the fact that wages were up 4% above the Q2 3.4% gain and it’s just another data point that nips at the heels of corporate margins.

Heart of the Problem

The good news is that corporate margins for now are still improving as pointed out by Goldman’s Jan Hatzius in a recent note. The Goldman chart above goes right to the heart of the problem. Corporate margins are sustainable only if you can continue to increase prices and or productivity. There are limits to both. Demand destruction comes in many forms and there is a price point in almost every product that forces a change in consumer behavior.

“It’s like Déjà vu all over again– Yogi Berra

Energy prices continue to climb and with the administration’s pivot back to OPEC to fill increasing demand once again Americans find themselves dependent on foreign oil. Energy touches every line item in the income statement.

While most Americans support efforts to move to a greener society how many will still be on board when it costs $200 to fill the SUV? Don’t ask them now. Ask them after energy costs have risen to a point that forces 70’s behavior. Americans in sweaters and coats sitting in a cold living room to control heating bills or only filling their gas tanks on designated days of the week. Any rational view of shifting to green energy has to include increased fossil fuel production to meet the needs of a growing economy until green energy can sufficiently scale.

Transitory?

At what price for oil and natural gas does demand destruction take hold forcing both the consumer and industry to cut back. With markets hitting all-time highs on an almost daily basis it doesn’t look like anyone is concerned or simply believes what we’re seeing is as the Fed puts it transitory. We’ll see how transitory it feels this time next year.