It is easy to sum up the earnings picture for 2021: It is good now and it should stay good. When all companies have reported for the second quarter, earnings are expected to be 65% higher than they were in the second quarter of 2020. Market consensus is for a 40% year-over-year earnings increase in the third quarter (and 12% annualized over the third quarter of 2019) as profits continue to rebound.

But as analysts we are always on the lookout for what might go wrong. Right now the market is focused on two main concerns, inflation and the Delta variant of Covid-19. Inflation has gotten most of the attention, but we think that is a mistake. Inflation should be manageable; the Delta variant is a true wild card. It is the one we will be watching most closely as the year unfolds.

Inflation
The Consumer Price Index is up over 5% year-to-date as of June 30, 2021, for the first time in more than 30 years. While 5% is high by the standards of the recent past, it is worth noting that in the late 1970s and early 1980s the inflation rate hit 10%.

What is driving prices? The answer comes straight out of an economic textbook: an imbalance between supply and demand. Supply is constricted right now in several areas. Workers are in short supply as the economy recovers from the pandemic, as well as severe weather disruptions and Suez Canal Blockage to an increasingly global supply chain.     

Some products are in short supply as well, as companies struggle to ramp up production. The chip shortage has hurt the technology industry and has hit the automobile industry hard. Automakers haven’t been able to make enough new cars, which in turn, has boosted the prices of used cars.   

Materials companies have felt the sting too. PPG, a paint and industrial coatings maker, reported a significant earnings miss in the second quarter, the result of having to pay inflated prices for oil-based derivatives.  

On the demand side, the story could not be more different. U.S. consumers, bolstered by government aid and fatigued after a year of lockdowns and partial lockdowns, are ready to spend. Credit card data support this. The three largest credit card issuers in the United States—Bank of America, Chase and Citigroup—have seen credit card purchase volumes increase by 12%, 16% and 11%, respectively versus 2019. Delinquencies and losses are down.  

We expect that a lot of what’s driving inflation to be a temporary mismatch of supply and demand. Over time, we predict markets will adjust and prices will come back into balance.  

We have already seen that adjustment in the lumber business. Prices rose sharply earlier this year to the point where the National Association of Home Builders said lumber alone had added $36,000 to the price of a new single-family home. But prices peaked in May and have declined dramatically since then. Production has increased and demand has eased as buyers wouldn’t or couldn’t pay the higher prices. This is how markets are supposed to work and we expect to see something similar in other industries. We are not the only ones who hold this opinion. The U.S. Federal Reserve has said inflation is likely to be transitory. The bond market, where yields remain very low, even on 10-year Treasuries, presumably feels the same.

 

The Dangers Of Delta
The Delta strain of Covid-19 first appeared in the U.S. in March and now dominates new coronavirus cases. It is more easily transmitted than earlier versions of the virus and is spreading rapidly, especially in communities where fewer people are vaccinated and fewer people practice social distancing. While it is impossible to forecast the future of this disease, it is conceivable that spikes in cases could cause additional lockdowns in the U.S. as it has globally. This could change people’s behavior enough to constrain their spending and travel habits, both in this country and overseas. This isn’t a prediction, just a concern.

In general we are sanguine about the earnings outlook, but we would be remiss if we weren’t on the lookout for developments that could change our opinion.             

Qie Zhang is director of Aberdeen Standard Investments.