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Inflation spooks the market

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On Wednesday, inflation data left markets concerned as investors gripped with the idea of higher inflation leading to rate hikes from the Fed. Myles Udland explains how this could be a good thing for corporate profits as consumer demand might be moving faster than expected.

Video Transcript

JULIE HYMAN: Let's continue our inflation talk, shall we? And the morning brief this morning, of course, from Myles was indeed on the topic of inflation and what is fueling it. And the idea that demand is a big part of the equation was definitely part of that. I want to mention, though, once again-- and I want to emphasize what you said yesterday that you repeated today Myles, because I think it's an important point that not everyone realizes. And that is, inflation is not the absolute price going up and staying there. It is the rate of change.

So in other words, transitory means that inflation rises 4% or whatever it is in a given month. But it doesn't keep rising at a rate of 4% for the foreseeable future, right? At some point that goes to 2%, and then 1%, and then whatever it may be. And just to emphasize that point, that's what transitory means in the context of what the Fed is looking at.

MYLES UDLAND: Yeah, it does. And then, you know, they drill it down in today's morning briefing a little. And I think as I read it today, maybe I could have been a little more explicit in sort of the argument that interests me most-- and this comes from Guy LeBas over at Janney-- which is that inflation, the inflation dynamic we are seeing today, a demand-driven inflation dynamic, is quite bullish for corporate bottom lines.

And it comes back to a topic that we've also written about in the morning brief and also talked about on this program, and I know is near and dear to Sozzi's heart, which is operating leverage. How much of each incremental revenue dollar can you turn into profit? Companies at the beginning of economic cycles tend to have the highest amount of operating leverage to exert on their model, which basically is a fancy way of saying, the more money that customers give them, the more easily they'll convert those new dollars into additional profits.

And so when we were talking about companies in the prior segment passing along higher costs to their consumers, well, they're doing that to either alleviate-- or not either. They're certainly alleviating some of their pressures on the cost side. But they also believe that they as the seller of a good can be a price maker, not a price taker, in the market, that consumers will accept higher prices because they have more money, they have more confidence, and that those higher prices-- consumers pay them-- will thus convert into more profits.

And so the read on this cycle is that corporate profits are driven simply by a stronger economic backdrop and that companies which were already positioned to see profit margins increase into this expansion might have an even stronger backdrop against which to do that. If we are seeing companies continue to compete for labor-- think about the McDonald's, the Amazon story-- that's more pockets in the consumers of more people giving more money back to more companies for more goods and services, with those companies having an ability to earn more profits on those incremental sales.

So again, the corporate profit read-through is that a demand-driven inflation cycle should be bullish for the bottom line. So all else equal, Sozzi, that's good for stocks. Higher profits means higher stock prices. That's not the way the market works on a short-term basis, even a multi-year basis. But over the longer term, profits are what determine the level of stocks.

BRIAN SOZZI: So inflation is good for stocks. It's interesting, because we were circulating a note--

MYLES UDLAND: Exactly.

BRIAN SOZZI: All right. We were circulating a note in our newsroom yesterday that one of the biggest or most searched for topics right now on Google is, how does inflation impact stocks? And it a long way, I think, to-- it gives insight into folks, what they're searching for. A lot of folks-- I would say a lot of these new retail investors we've seen in the market haven't seen inflation levels like this before.

But Myles, I do wonder-- because I think a lot of the companies we talked about in the last segment, a lot of those consumer companies raising prices-- that was their first round of price increases. Another round of price increases are likely coming. At what point does this start to stun, let's say, retail sales reports or corporate bottom lines?

MYLES UDLAND: Yeah, I mean, look, I think-- like, yesterday's market action, Sozzi, suggests that the market is worried about that right now, that that's the primary read from the market, that inflation is bad because not only does it hurt the bottom line. It also means in theory the Fed is going to raise rates sooner. And again, all else equal, higher interest rates is worse for stocks.

The relationships of all these things is not necessarily as simple as those kind of axioms. So again, that's why we're saying, look, better profits should be better for stocks. Higher rates should be worse for stocks. It need not necessarily play out like that each day so simply.

But to your point, I think the bias, for sure, is that inflation is bad. Inflation is something for investors to be nervous about, for consumers to be nervous about. But I think there are ways of looking at the current situation and saying, you know, this may be a more bullish sign or a more constructive sign economically, financially, and so on and so forth, than it would appear at first glance.

JULIE HYMAN: Well, and of course, the Fed wants inflation to a certain point. That's the whole point of keeping rates where they are. I should mention, by the way, we've got retail sales tomorrow morning, to Brian's point about how this is going to feed through to consumers. That's going to be really interesting.