Inflation Concerns Dividing Market
Investors increasingly are separating the haves from the have-nots on Wall Street.
The haves are companies that appear to have the ability to perform well in an environment of rising interest rates and higher inflation.
The have-nots, well, don’t -- or at least, that’s how many investors see them at the moment.
Last week, as Treasury bond yields reached their highest levels in at least four months and the government reported a bigger-than-expected jump in inflation in March, stocks overall struggled.
But even as the blue-chip Standard & Poor’s 500 index lost a net 0.4% for the week and the technology-heavy Nasdaq composite slumped 2.8%, there were plenty of winners in the equity market.
Paper and lumber producer Georgia-Pacific Corp., for example, closed at a 2 1/2-year high of $36.45 on Friday and gained 7.4% for the week. The company said Wednesday that its first-quarter earnings would beat expectations because of robust demand for building materials.
Stryker Corp., a manufacturer of hip implants and other medical devices, jumped $4.06 to a record $99.66 on Friday, after reporting that first-quarter profit soared 31% on a 22% rise in sales.
Georgia-Pacific and Stryker are in two very different businesses. But both are representative of ideas that are resonating with investors this year.
In Georgia-Pacific’s case, the idea is to cash in on improving prices for basic commodities, a source of inflation as the economy advances; in Stryker’s case, the idea is to find companies that may have strong sales prospects even if rising interest rates slow other businesses later this year.
The threat of higher rates dominated the talk on Wall Street last week, particularly after the government said the consumer price index rose 0.5% in March and at an annualized rate of 5.1% in the first quarter.
The inflation data, following weeks of mostly upbeat economic reports, deepened concerns that the Federal Reserve would begin tightening credit by late summer, pushing interest rates up to slow the economy. Treasury bond yields, which have surged since late March, are reflecting those concerns.
Higher interest rates mean stocks face more competition for investor dollars, and they also threaten corporate earnings by raising the cost of borrowing. What’s more, higher rates typically guide investors to lower the prices they’re willing to pay for stocks relative to expected earnings.
At Standard & Poor’s in New York, chief investment strategist Sam Stovall said the research firm remained “relatively bullish” on stocks. But the firm last week cut its year-end forecast for the blue-chip S&P; 500 index from 1,230 to 1,215. The lower estimate, if achieved, would be a gain of 7% from the S&P; index’s close of 1,134.61 on Friday.
“We still believe equities offer a better return opportunity than bonds and cash,” Stovall said, “but the prospect of higher interest rates has tempered our enthusiasm.”
Like many advisors, S&P; is telling investors to be wary of financial and utility stocks, two groups that historically have been viewed as victims when rates are moving up.
An S&P; index of six big U.S. bank stocks fell 1.6% last week; the Dow Jones index of 15 utility stocks dropped 2.3%.
Thomas McManus, an investment strategist at Banc of America Securities in New York, also is urging clients to be more cautious about the stock market because of the trend in interest rates.
Even so, he said, “We believe that certain sectors and stocks are less likely to be damaged by rising rates.” He favors companies in sectors such as energy, basic materials (commodities) and healthcare.
Wall Street, always looking for something to sell, might be accused of trying to make lemonade out of lemons in the current environment.
But the offset to higher interest rates in a strong economy is that many companies are posting healthy profit growth, which naturally attracts investors’ attention.
About one-fifth of companies in the S&P; 500 index have reported first-quarter financial results. On average for those firms, operating earnings were up 30% from a year earlier and sales were up 14%, according to earnings tracker Thomson First Call in Boston.
“There are more companies reporting upside surprises and by a larger amount” than usual, Thomson said. It said 72% of reports have beaten expectations, compared with the historical average of 58% for any given quarter.
One factor helping earnings is that better demand for goods and services allows more businesses to raise prices somewhat.
“Companies, enjoying better times, are likely to start testing their pricing power,” said Donald Straszheim, economist and head of Straszheim Global Advisors in Santa Monica.
A logical place to look for better pricing power is in sectors in which first-quarter sales were up sharply, analysts say. One is industrial equipment. Eaton Corp., which makes hydraulic systems for machinery, last week said first-quarter sales jumped 16% from a year earlier and earnings soared 86%. The stock rose 4.9% for the week, to $60.02 by Friday.
Similarly, many experts who believe that energy prices are likely to stay high say oil and gas companies’ earnings growth should be a pleasant surprise all year, regardless of interest rates. An S&P; index of six major international oil stocks, including Exxon Mobil Corp. and Amerada Hess Corp., was up 2.9% last week, the third straight weekly gain.
On the downside, shares of semiconductor giant Intel Corp. slid 3.4% last week, to $26.45 by Friday. The company said Tuesday that first-quarter earnings surged 89% on a 21% rise in sales. But Intel also predicted that sales this quarter would be at the lower end of analysts’ anticipated range.
The last time the Federal Reserve went on a major credit-tightening binge -- in 1994 -- many technology stocks performed extraordinarily well, as their growth prospects trumped worries about interest rates.
A Morgan Stanley index of 35 big tech shares rocketed 35% in 1994. It had struggled early in the year (when the Fed’s rate increases began), then rebounded in the second half.
This time, however, tech-stock prices relative to earnings are far above their 1994 levels. That may make it more difficult for the sector to rise further if interest rates increase, some analysts say.
“Valuation unquestionably remains problematic in the information technology sector,” brokerage Goldman, Sachs & Co. warned clients in a report last month.
Tobias Levkovich, chief U.S. equity strategist at brokerage Smith Barney in New York, said Friday that he was girding for a possible drop of 15% in major market indexes this summer.
He listed technology and banking as two sectors that might be most vulnerable to interest rate worries.
