Equities reset with margins and structural inflation themes back

Home Depot and Walmart confirms wage pressures and margin compression

Yesterday’s results from Home Depot and Walmart confirmed that wage pressures are still high with Home Depot setting aside an extra $1bn to their hourly frontline staff. Home Depot’s guidance on operating margin at around 14.5% is lower than the estimated 14.8%. Home Depot is one of the biggest winning stocks of the past three decades in the US equity market and in theory a Berkshire Hathaway acquisition target. While yesterday’s earnings release is a setback for the company and the strong pandemic boom narrative is seeing cracks it will likely be too early for value investors to get into Home Depot shares as the company is still valued significantly above the general equity market and its own long-term average valuation since 2003.

The margin compression theme we have written extensively about for several quarters picked up during the Q4 but overall companies still managed their margins a bit better than feared. However, despite energy and general commodity prices have eased over the past six months, the pressures from wages will begin eating into margins. The equity market’s sensitivity has moved from interest rates to that of operating margin because companies’ margins are rolling over from historically high levels.

The worst-case scenario this year for equities is if the bond market wakes up to the realisation that inflation is becoming more structural and less temporary. That could cause long-term bond yields to push higher and increase the equity risk premium at the same time. If that happens while earnings face an operating margin headwind then the equity market could faces significant trouble. We continue to maintain that under higher structural inflation equities will do better than bonds, but it is important for investors to be overweight companies operating in the physical world and also consider being overweight Europe vs US equities.