I’ve been raising two major concerns to my readers recently:

1.  Consumer wages are rising slower than inflation;
2.  Business incomes aren’t growing much and they continue to suffer from excess supply

Consumer Discretionary Spending Falling

Moneyball readers…Inflation is here.

We can see the impact of inflation as consumers shift away from discretionary items.

You likely have noticed the higher prices at the pump.

Gas prices are at a 2 year high – up 40% since last year. It happened so rapidly, the higher prices are squeezing out spending on other things.

The latest read on Retail Spending found that consumers cut back spending on simple pleasures in life like going out to eat (Gasoline spending: +$700 million, Food Services: – $700 million).

The inflation doesn’t stop there.  

Since 70% of all goods in the US get shipped by trucks – which pass on higher fuel costs –  virtually all goods are going to go up in price.

(Watch your consumer-oriented investments.)

The palpable shift in consumer spending means staying away from retail and food services stocks. Luxury goods companies will be particularly hard hit. One case in point, Signet (SIG) a major jewelry chain company. Signet missed sales badly which caused its stock to fall more than 3% the next day (Its stock is down more than 30% over the past 12 months).

Mixed news for the Stock Market

4Q Business Activity More Of A Blip Than A Shift To Greater Demand

If you’re a long-time Moneyball reader, you’ll know I exited the stock market a few months ago. I’ve missed this huge rally. But I was right in my assessment of the economy and the challenges ahead.  

What I really missed was a massive price-to-earnings (P/E) multiple expansion.

Step back and you will realize one fundamental point going on in the stock markets: revenues are on a downward trend for most companies, but valuations are hitting new levels. Per Case Shiller, P/Es are:

• The highest in 17 years (since the 2000 dotcom boom);
• Have surged in the last few months

What’s going on is that companies are seeing rising earnings growth but falling revenue growth. The market is ignoring (for now) the issue of slowing/sluggish business growth and focusing on the fact that companies are squeezing out earnings growth.

Margin Expansion

You’ll see margin expansion during earnings coming up. But you’ll still see companies in wait-and-see mode.

Let’s run with the idea that the stock market is up because of better margins. How those margins materialized and whether they are sustainable are key questions. Because right now… stock prices are priced to perfection.

One reason for margin expansion is that throughout 2016 companies focused on expense management. Now comes the payoff.  Any uptick in sales comes with even higher margins: companies aren’t spending or hiring more to get that business.

But wait, you may be thinking,  “You just told us sales were slowing, so where’s the uptick in business?”

Imagine a drunk driver weaving down the road: they zig to the left, and then they course correct and zig to the right. But the overall direction doesn’t change.

That’s what happened in the fourth quarter (Q4), the one companies are reporting now.

There were signs companies had to restock inventory heading into Q4.

For example, semiconductor companies were reporting that their customers had inventories that were too lean.After the election, the coast was clear and companies had to start meeting pent-up demand. That restocking is apparent in the recently reported huge jump in inventories.

The main point: spending moved up AND supplier prices moved up. The lean inventory meant that the uptick in demand (the drunk driver swerving right) allowed suppliers to raise prices temporarily (or at least keep them from falling further).  

That creates margin expansion for industrial companies. Additional gross margin expansion is also possible as many companies jump on the inflation bandwagon and try to boost prices regardless.

This is key for market sentiment because industrials lead earnings season and will tend to set the tone.

The stock market setup is as follows:

1. EPS growth accelerates for industrial companies;
2. The market pats itself on the back for correctly anticipating the EPS strength;
3. The market extrapolates Q4 growth for all of 2017;
4. The market extrapolates industrial margin expansion to all of the economy;

Everything hinges on whether or not the post-election activity was a mild blip or a complete re-boot and economic reflation.

Companies In Wait-And-See Mode

Economic sentiment turned positive post-election. (That’s a big understatement.)

But, as we’ve noted before, positive sentiment doesn’t always turn into positive spending.  

Retail spending excluding Autos & Gas were flat in December.

Consumers are happy, but it doesn’t mean they are (and will) spending more.

Is the Q4 activity a shift in trajectory?  No.

Overall, the story still remains the same: excess supply and mild demand. Companies have no incentive to increase capital expenditures, operating expenditures, or hiring. Any firming of prices will be possible only if demand continues to grow beyond short-term re-stocking.

There will be some impact on the margins because some companies will reconsider their plans for pre-emptive layoffs.

Coming into Q4 2016, companies were starting to consider layoffs in Q1 2017. Today, they have put those plans on pause. Companies want to see the optimism manifest as higher spending. And for a sustained period (3+ months).

But there’s a chance the rug will be pulled out from under the stock market.

The market is calling out reflation (an economy expanding) when all we’re seeing is oil inflation and some general restocking.  

Right now, what’s good for industrials is bad for the economy because everyone gets hit with inflation. And as noted at the beginning, inflation is already driving down consumer spending and forcing a shift in the quality of spending.

More inflation will push that shift in consumer spending even more so. Higher prices may be good for suppliers, but it squeezes the margins of buyers.

KEY TAKEAWAY: Inflation is here thanks to massively higher fuel prices.  That is squeezing companies and consumers alike.

In the short-term, companies have some benefits. They cut spending in order to maintain margins and we’re starting to see some margin expansion. But the market is extrapolating this situation as (1) a permanent change in the US economy and (2) affecting all companies equally well.

INVESTING THOUGHTS

1. Overweight industrials for this quarter.  Still upside surprises.  Consider companies that are less globally exposed and more domestic (that avoids the messiness of a stronger dollar).  
2. Underweight any retailer or consumer-oriented company, especially those that serve lower income households.  Higher prices at the pump hit these households hardest and force them to spend less on clothing and TVs.