Cooling inflation can be bad for stocks. Here's how

By Frances Yue

While investors are celebrating signs suggesting U.S. inflation is slowing down, such a trend may negatively impact company earnings and in turn weigh on stock prices, as companies release their second-quarter financial results while the Dow Jones Industrial Average is on pace to record its 12th straight day of advance.

"Stock prices are a combination of a multiple and earnings, and while disinflation may be good for the former, it could be negative for the latter," said Tom Essaye, president at the Sevens Report Research.

When companies raise prices significantly, consumer demand usually evaporates, resulting in higher profit margins for companies and lower aggregate sales numbers. However, during the past few years, consumers kept buying despite high prices, due to high amounts of personal savings and low unemployment coupled with a recovery from the repressed demand during the pandemic, Essaye wrote in a recent note.

"The result was great for corporate America -- higher margins and higher sales," Essaye wrote. "However, disinflation will pose a threat to that positive mix."

It is important to watch commentary on pricing and consumer demand in the current earnings season, Essaye said. "Because as inflation falls, so will many companies' margins and profits, and that's not something that's priced into stocks right now and provides some downside risk into earnings," Essaye wrote.

All three stock indexes are trading at levels close to their 15-months high, according to Dow Jones market data.

Read:As tech stocks skyrocket, here are the S&P 500's best and worst sectors for profit margins

Meanwhile, as inflation slows down, "that means earnings expectations that were perhaps predicated upon a higher and a more consistent inflationary rate will also come down," Eric Freedman, chief investment officer at U.S. Bank Wealth Management, said in a phone interview.

What's more, during periods of inflation, "investors and company managements conflate nominal mismatches between topline prices (CPI, if you will) and input costs (PPI) with sustainable improvement in profits margins," Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management wrote in a recent note.

CPI refers to the consumer price index, which is used to calculate cost of living adjustments while PPI stands for the producer price index, which is usually used to calculate real growth.

"While the spread between these metrics is historically wide, such a dynamic rarely holds. CPI minus PPI is mean-reverting to zero, and plummeting prices, as suggested by prices paid indexes, usually take margins with them after a six-month lag," Shalett wrote.

Domestic-oriented companies in the U.S. are likely to experience more pressure brought by disinflation, noted Michael Green, head of Investment strategy at Simplify Asset Management. While multinational companies may have more exposure to the slowdown of economic growth in China and Europe, the disinflationary pressure is mostly offset by a weakening dollar, Green said.

To be sure, prices are still going up even though the rate of inflation is decelerating.

"Prices are going up more slowly. It is good. But they're still going up. And they're still going up faster than the Fed wants them to go up," said Steve Sosnick, chief strategist at Interactive Brokers.

See: U.S. economy grows at slowest pace in 5 months. Inflation 'sticky,' S&P says

While the market expects the Federal Reserve to raise its benchmark interest rate by 25 basis points in their meeting that concludes on Wednesday, it remains uncertain if the U.S. central bank will raise its interest rate for more.

Traders are pricing in an over 30% likelihood that the Fed will deliver one more rate hike after July, according to the CME FedWatch tool.

Also read:Everyone thinks Fed's rate hike this week will be the last one -- except the Fed

U.S. stocks advanced Tuesday, with the Dow Jones Industrial Average up 0.3% and the S&P 500 up 0.4%. The Nasdaq Composite rose 0.8%.

-Frances Yue

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07-26-23 1056ET

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