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Matthew Finn, CFA
Head of Equity Mutual Funds

MARKET UPDATES

Pandemic impacts on prices, productivity, & profits

10/26/2021
By Matthew Finn, CFA, Head of Equity Mutual Funds  | 10/26/2021

Thrivent Asset Management Contributors to this report: Roger Norberg, Director, Equity Research; John Groton, Jr., CFA, Director of Administration and Materials & Energy Research; Brian Flanagan, CFA, Senior Portfolio Manager, Thrivent Mid Cap Stock Fund, and Jim Tinucci, CFA, Senior Portfolio Manager, Thrivent Small Cap Stock Fund

Macroeconomic statistics, such as gross domestic product (GDP) growth, unemployment, and inflation, provide the headlines that tend to influence the overall direction of the equity and bond markets.

These statistics garner most of the attention from economists, policy makers and the press. However, in managing a portfolio of securities, especially equity securities, the microeconomic impact of macro developments is much more important to overall investment returns. Recently, sharply higher inflation and its potential impact on corporate profits has come into sharper focus.

Microeconomics provides information on the interaction of supply and demand which ultimately determines price trends for materials, goods and labor. At a macro level, inflation statistics are a comprehensive snapshot of overall price developments in an economy. At a micro level, inflation dynamics affect corporate pricing power, revenue, and input costs. Obviously, profits are a function of the degree to which revenues exceed costs – and it is profitability that ultimately drives a company’s stock price.

The COVID-19 pandemic has added a unique dimension to the multiple issues and risks that face corporate managers. It has also provided unique opportunities for various companies that are able to adeptly navigate a new and changing environment. Understanding these changing microeconomic dynamics and appropriately positioning portfolios for long-term success is a key challenge now facing investment managers.

The macro environment

Prior to the Covid pandemic the economic and business environment was characterized by the following long-running factors that were keeping inflation extremely subdued:

  • Lingering effects of the 2008 financial crisis,
  • Sluggish global growth, especially in Europe,
  • A decade of extremely accommodative monetary policy by the Federal Reserve (Fed),
  • Global overcapacity in many industries,
  • Depressed commodity prices,
  • Offshoring of supply sources and manufacturing to lower cost countries, especially Asia,
  • Stagnant real wages.

As consumers, businesses and governments worldwide became more aware of the serious consequences of COVID-19, all reacted in ways that altered some of the long-running factors that had been influencing the economy and inflation. Consumers immediately stopped spending and began saving at a level not seen in decades. Businesses responded by cutting production of goods while pulling back in investment spending.

Finally, the government responded by showering the economy with money; first with a monetary policy initiative by the Fed that injected substantial liquidity into the financial system, followed by massive fiscal spending programs that sent dollars directly to consumers and businesses.

Meanwhile another long-running development in the economy became evident – the profound productivity impacts being delivered by advances in computing power, software, and broadband internet connectivity.  These advances provided the key infrastructure that allowed for economic activity to continue, if not actually flourish, for certain industries and companies.

The micro environment

The unusual pandemic macro environment, where supply was sharply curtailed by private enterprise reacting to incredible uncertainty, while demand was being fueled by massive fiscal and monetary public policy support, led to significant microeconomic imbalances across industries.  In short, resurgent demand was met with sharply constrained supply, leading to dramatically higher prices.

Understanding the impact of shifting microeconomic variables – and the strategies that corporations will be pursuing to manage these new risks and opportunities – will be a critical dimension for equity investors to assess.

There are five key areas that corporations will need to successfully navigate going forward. They are: material cost inputs, labor shortages/wages, logistics, technology/productivity improvement initiatives, and environment/social impact.

Material costs

Material cost issues will more directly affect industrial, automotive and consumer durable-related companies. Rapidly rising energy cost issues have also emerged, which will affect these industry groups as well as the fuel-dependent Transportation sector. The Information Technology and Communication Services sectors are largely immune from the pressure of rising material costs. However, they will have to deal with component supply and cost pressures, especially in semiconductors.

Labor costs

Labor availability and sharply rising wages seem to be affecting all areas of the economy but are particularly acute in industries that employ a significant number of lower compensated workers. The leisure/hospitality, food service, consumer services, construction and transportation related businesses are all challenged with increases in pay and benefits essential to attract and retain workers.  This is an area where well-managed companies that previously recognized the value of their employees – and who have assertively worked to develop and retain workers – may benefit relative to their competitors.

Logistics

A significant contributor to rising costs is not just from the rising cost of materials, but in the logistical cost of transporting materials and goods to their end destination. Logistical challenges cut across nearly all manufacturing industries. Covid protocols and international quarantine mandates combined to snarl complex, global supply chains. Near-term logistical challenges are slowly being resolved, but longer-term questions remain regarding the reliability of obtaining necessary inputs from far-flung suppliers. Companies that have more diversified supply sources, simplified supply chains, and more domestic supply orientation may be better positioned for this more secular challenge.

Technology/productivity response

It is not an exaggeration to state that technological innovation and productivity enhancing investments were critical in supporting the global economy. In fact, many companies actually flourished in this environment, and were rewarded with sharply rising stock prices.

The pandemic pushed companies to find or to pull forward cost reduction or efficiency improvements that will lead to lasting productivity gains and to sustained higher levels of profitability. Until now, the obvious beneficiaries of these developments were the large technology-oriented companies. However, astute managers across many industries who successfully implement innovative changes to their operations, can also benefit. These benefits may come not just from managing costs, but also from changes that can fuel incremental revenue.

Environmental/social impact

Consumers, corporations, and investors have gradually come to understand the reality of environmental and social costs that come with economic activity. Fortunately, there are not just negative cost issues to manage, but also new positive dimensions of opportunity for forward-thinking corporations.

The emerging electric vehicle (EV) secular change in the auto and energy sectors is a great example of this new dimension. Properly assessing and responding to various environmental/social opportunities and costs is beginning to become a differentiating feature of success for businesses across all industries.  Understanding these impacts and changes is also increasingly important to successfully managing equity portfolios.

Transitory – or not – impact

The Fed’s response mantra regarding the question of inflationary impulses is that they are “transitory.” In certain areas, especially in the area of commodity materials, it seems that may be the case given that pre-pandemic secular forces may reassert themselves. However, it is difficult to see how cost pressures coming from increasing labor demands will be transitory. Once labor costs start to rise, they are difficult to subdue. So, from a macro standpoint, it is unclear if inflation will eventually settle back into the Fed’s target range of around 2%.

To corporate managers, the debate around whether or not inflation is “transitory” is less relevant. They need to deal with the micro challenges and opportunities the pandemic has created.

For investment managers, successfully navigating a portfolio going forward will depend less on correctly assessing macro elements that have been such a key driver to overall market returns over the past number of years, and more on micro elements that will have heterogenous impacts on long-term corporate profits across industries.  This will be even more important given the current environment where valuation across asset classes is at historically high levels.

Our view is that a key philosophy to successful equity investing remains, even in this dynamically changing macro and micro environment. It is to understand the fundamentals of corporations and the industries in which they operate and focus on those that demonstrate the ability to achieve superior operating performance such that they are able to sustain long-term high returns on invested capital relative to their cost of capital.  


All information and representations herein are as of 10/26/2021, unless otherwise noted.

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.


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