Passing the buck

Pricing power is highly prized on Wall Street

At the moment there is a glut

Mcdonald’s has employed a “barbell” pricing strategy for decades, luring customers with low-cost items in the hope that they will then splurge on pricier fare. 

This balancing act is now at risk. On October 27th the fast-food giant said that, due to rising costs, prices at its American restaurants will increase by 6% this year compared with 2020. 

The burger chain says labour expenses have risen by 10% at its franchised restaurants and 15% at its company-owned locations. 

Add the rising cost of ingredients and the result is higher prices for burgers and fries. 

For now, it seems, customers can stomach it. 

Chris Kempczinski, McDonald’s boss, said the increase “has been pretty well received”. 

After digesting the news, investors have sent shares in the fast-food firm up by 6%.

A growing number of companies are raising prices as costs for labour and raw materials rise, often with no ill effects. 

This summer PepsiCo, an American food giant, lifted prices for its fizzy drinks and snacks to offset higher commodity and transport costs; it plans further increases early next year. 

Ramon Laguarta, the firm’s boss, suggested in an earnings call in October that customers do not seem bothered. 

“Across the world consumers seem to be looking at pricing a little bit differently than before,” he said. 

In September Procter & Gamble, a multinational consumer-goods giant, raised prices for many of its products. 

The effect on demand was minimal. 

“We have not seen any material reaction from consumers,” Andre Schulten, the firm’s chief financial officer (cfo), told analysts last month.

“Pricing power”, the ability to pass costs to customers without harming sales, has long been prized by investors. 

Warren Buffett has described it as “the single most important decision in evaluating a business”. 

It is easy to see why. 

When hit with an unexpected expense, firms without pricing power are forced to cut costs, boost productivity or simply absorb the costs through lower profit margins. 

Those with pricing power can push costs onto customers, keeping margins steady.

Today, firms are eager to flaunt their price-setting clout. 

“We can reprice our product every second of every day,” Christopher Nassetta, boss of Hilton Worldwide, a hotel operator, told investors last month. 

“We believe we’ve got pricing power really better than almost anybody if not everybody in the industry,” boasted John Hartung, cfo of Chipotle, a restaurant chain, in October. 

Companies such as Starbucks, Levi Strauss and GlaxoSmithKline make similar claims. 

“We are a luxury company, so we do have pricing power,” bragged Tracey Travis, cfo of Estée Lauder, a cosmetics firm, on November 2nd.

They are not alone. 

Of the s&p 500 companies that have reported third-quarter results, over three-quarters beat projections, according to Bank of America Merrill Lynch. 

“This earnings season there was a lot of angst on the part of investors that higher input costs would erode margins,” says Patrick Palfrey of Credit Suisse, a bank. 

“In fact, what we have seen is another spectacular quarter on behalf of corporations so far in spite of input cost pressures.” 

According to Savita Subramanian and Ohsung Kwon of Bank of America mentions of “price” or “pricing” in American earnings calls—a proxy measure for pricing power—increased by 79% in the third quarter from a year earlier. 

In the second quarter, such mentions were up by 52% year on year.

If costs spiral out of control, the power to raise prices will become ever more important. 

On November 2nd JPMorgan Chase’s global purchasing-managers index, a measure of manufacturing activity, showed that input prices in the sector increased in October at the highest rate in more than 13 years. 

But the prices of manufactured goods and services also rose at the fastest pace since records began in 2009. 

A gap between input and output price inflation is typically interpreted as a sign that firms are struggling to raise prices and that margins are being squeezed. 

That isn’t happening yet.

Identifying firms with pricing power is crucial for investors. 

Analysts tend to look for three things. 

The first is a big mark-up—the difference between the price of a good and its marginal cost—which only firms with market power can get away with. Big and steady profit margins are another sign of pricing power. 

“If you are a firm that is dominant in your market, you are much more resilient to shocks,” explains Jan Eeckhout, an economist and the author of “The Profit Paradox”, a book published earlier this year.

Size is another factor. 

All else equal, bigger companies with greater market share have more pricing power than smaller ones. 

A recent survey of American cfos conducted by Duke University and the Federal Reserve Banks of Richmond and Atlanta found that 85% of large firms reported passing on cost increases to customers, compared with 72% of small firms.

A “pricing-power score” for companies in the s&p 1500 compiled by ubs is based on four indicators: mark-up, market share, and the volatility and skew of profit margins. 

The bank found that firms providing consumer staples, communication services and it have the most pricing power and that energy, financial and materials companies have the least (see chart 1). 

When ubs compared the financial performance of companies with strong and weak pricing power, they found that the former have delivered more profit growth since 2010 and generated better stock returns, particularly during periods of high inflation (see chart 2).

Firms that score well on this index have lagged in the past year, notes ubs. 

This may be explained by cyclical factors. 

When profit margins are expanding, the argument goes, firms with pricing power tend to generate relatively low returns; when margins are shrinking, they produce high returns. 

At the moment, profits are still healthy.

For now, demand is robust and consumers seem relatively insensitive to price changes. But companies are planning more price increases. 

A survey by America’s National Federation of Independent Business, a trade group, found that the margin of small-business owners planning to raise prices in the next three months over those planning to lower them grew to 46%, the biggest gap since October 1979. 

This is a concern for some central bankers such as James Bullard, president of the Federal Reserve Bank of St Louis. 

In October he noted that for years companies have worried that if they raised prices, they would lose market share. 

“That may be breaking down,” he says. 

Why innovation could stop inflation

Technological progress may be the most powerful disinflationary force in a changing world

Rana Foroohar 

© Matt Kenyon

It seems that nearly every economic conversation these days revolves around inflation. 

Each question seems to lead to another. 

Is it transitory? 

Will it get worse? 

If so, when? 

And for how long? 

Which of the many factors — including soaring post Covid-19 demand, supply chain shortages, fiscal and monetary stimulus, energy politics, or all the many changes in how we live, work and play post pandemic — should matter most as we try to build a picture of what’s happening?

In all the debate, one point gets very little discussion: the role of technology as arguably the most important variable in what might happen to inflation over the coming several years.

For every inflationary factor, from labour shortages to transportation bottlenecks, fuel costs, or even longer-term pressures like an ageing population, there is a looming technological change that could shift the calculus around pricing in ways that are hard to predict.

Consider the clean energy transition. 

Already, demand for electric vehicles is pushing up the price of commodities such as copper, lithium, nickel, and cobalt. 

Green vehicles and power plants are much more metal-intensive than the technologies they are replacing. 

As more companies and nations move towards a carbon tax and seek to limit fossil fuel production, energy prices may rise further in the short term.

But the wider timeline is, of course, what matters. 

While a fast transition to a cleaner world will create some inflationary pressure, it will dramatically cut the cost of climate-related disaster in the longer term.

What’s more, technological innovation itself eventually lowers costs. 

Morgan Stanley data show that, short-term spikes aside, commodity prices have trended down for 200 years. 

That’s because every time one energy source became too expensive, a new one was invented to take its place.

We might be heading into a cold and expensive winter. 

But given the plummeting costs of renewable technologies such as solar panels and wind farms (and increasing public and private investment in them) there is good reason to hope that, with time, the final destination could be a much better and cheaper place — one that would put a dent in some of the 1970s stagflation analogies.

What about the inflationary aspects of supply chain delays? 

Some logistics experts believe port backups will last for years. 

And yet, already, we’re seeing the largest and richest companies (Amazon, Walmart and Costco, for example) adjusting to the problem with innovations of their own.

Those innovations will include more vertical integration (for example, owning rather than renting some of their own shipping containers to allow more control) but also using artificial intelligence systems to better track deliveries. 

Autonomous vehicles, both trucks and ships, are getting a new boost of interest. 

The first autonomous container vessel will be tested in Norway by the end of the year. 

If such systems smooth traffic, some supply chain-related delays and price pressures would begin to abate.

As the internet of things becomes ubiquitous, more companies will use new technologies to improve efficiency. 

As the chief executive of Ark Investment Management, Cathie Wood, noted in a recent interview, such innovations, which include autonomous mobility, blockchain, gene editing, adaptive robots and neural networks, are more likely to usher in a period of longer-term deflation than inflation, given the depth and breadth of their impact across all areas of business.

Certainly, they will disrupt labour markets in ways we can’t yet envision. 

Technology could, for example, play an important role in offsetting the inflationary pressures of ageing baby boomers, who will require more care at exactly the time the labour force is shrinking, by increasing the productivity of existing healthcare workers and the system.

China, which has poured $1.5bn into using big data in healthcare over the past decade (and many billions more into artificial intelligence) is likely to be the epicentre of AI-driven diagnostics and healthcare innovation.

The politics of using big data in sensitive areas such as healthcare and finance will, of course, vary from country to country, as regulators grapple with the social implications of such cutting-edge technologies. 

Those differences in national policies could themselves be inflationary if they contribute to cross-border frictions in global business and when it comes to the movement of people, goods and capital.

In a multipolar world, there will inevitably be more delays, shortages and supply and demand mismatches in the short term.

And yet, the fact that the global economy has become somewhat more fragmented over the past couple of years is also an opportunity for technology-driven innovation that could eventually bring prices down. 

Think about vertical farms that grow produce minutes from where people eat it, telehealth and virtual education platforms that eliminate travel costs, and 3D manufacturing that cuts through complex and far-flung supply chains.

These are just a handful of the many new technologies that are currently booming. 

The change such innovation could bring is arguably the only major disinflationary trend right now. 

But it may prove to be the most powerful. 


A quantum walk down Wall Street

Lessons for finance from 20th-century physics

Finance and physics have long been productive bedfellows. 

When he wasn’t writing the laws of mechanics and gravity, Isaac Newton ran the Royal Mint, making coins harder to forge and forcing counterfeiters to the gallows. 

The quantitative tools developed in 1900 by Louis Bachelier to study the French stockmarket were taken up by Albert Einstein to prove the existence of atoms. 

Norbert Wiener formalised them into a mathematical framework that remains at the heart of today’s financial models.

Yet finance has been slower to absorb other big ideas from 20th-century physics. 

That is perhaps unsurprising, because they are generally bizarre. 

Fire a beam of electrons through two slits onto a screen and they will pass through both at once, travelling as a wave but arriving as particles. 

Concentrate enough energy in a region of space, and matter and antimatter pop out of the void. 

Introduce the right two particles to each other and they pop back into it.

All this seems worlds away from the mundane reality of traders tapping out buy and sell orders on their keyboards. 

But on a closer look finance bears a striking resemblance to the quantum world. 

A beam of light might seem continuous, but is in fact a stream of discrete packets of energy called photons. 

Cash flows come in similarly distinct chunks. 

Like the position of a particle, the true price of an asset is unknowable without making a measurement—a transaction—that in turn changes it. 

In both fields uncertainty, or risk, is best understood not as a peripheral source of error, but as the fundamental feature of the system.

Such similarities have spawned a niche area of research known as quantum finance. 

In a forthcoming book, “Money, Magic, and How to Dismantle a Financial Bomb”, David Orrell, one of its leading proponents, surveys the landscape. 

Mr Orrell argues that modelling markets with the mathematical toolbox of quantum mechanics could lead to a better understanding of them.

Classical financial models are rooted in the mathematical idea of the random walk. 

They start by dividing time into a series of steps, then imagine that at each step the value of a risky asset like a stock can go up or down by a small amount. 

Each jump is assigned a probability. 

After many steps, the probability distribution for the asset’s price looks like a bell curve centred on a point determined by the cumulative relative probabilities of the moves up and the moves down.

A quantum walk works differently. 

Rather than going up or down at each step, the asset’s price evolves as a “superposition” of the two possibilities, never nailed down unless measured in a transaction. 

At each step, the various possible paths interfere like waves, sometimes amplifying each other and sometimes cancelling out. 

This interference creates a very different probability distribution for the asset’s final price to that generated by the classical model. 

The bell curve is replaced by a series of peaks and troughs.

Broadly speaking, the classical random walk is a better description of how asset prices move. 

But the quantum walk better explains how investors think about their movements when buying call options, which confer the right to buy an asset at a given “strike” price on a future date. 

A call option is generally much cheaper than its underlying asset, but gives a big pay-off if the asset’s price jumps. 

The scenarios foremost in the buyer’s mind are not a gentle drift in the price but a large move up (from which they want to benefit) or a big drop (to which they want to limit their exposure).

The potential return is particularly juicy for options with strikes much higher than the prevailing price. 

Yet investors are much more likely to buy those with strikes close to the asset’s market price. 

The prices of such options closely match those predicted by an algorithm based on the classical random walk (in part because that is the model most traders accept). 

But a quantum walk, by assigning such options a higher value than the classical model, explains buyers’ preference for them.

Such ideas may still sound abstract. 

But they will soon be physically embodied on trading floors, whether the theory is adopted or not. 

Quantum computers, which replace the usual zeros and ones with superpositions of the two, are nearing commercial viability and promise faster calculations. 

Any bank wishing to retain its edge will need to embrace them. 

Their hardware, meanwhile, makes running quantum-walk models easier than classical ones. 

One way or another, finance will catch up.

Fed Picks Leave Open Questions on How Central Bank Will Regulate Wall Street

Renominated Chairman Jerome Powell says he will defer to President Biden’s forthcoming nominee on financial regulation

By Andrew Ackerman and Orla McCaffrey

Under Federal Reserve Chairman Jerome Powell, the central bank has eased some bank regulations enacted after the 2008-09 financial crisis. / PHOTO: TOM WILLIAMS/ZUMA PRESS

WASHINGTON—President Biden’s decision to reappoint Jerome Powell as Federal Reserve chairman and elevate governor Lael Brainard signals continuity on monetary policy but leaves open questions on the direction the central bank will take in regulating Wall Street.

The extent to which the Fed will spend the next several years tightening regulatory policy—after easing rules under Trump-appointed officials—will depend on whom Mr. Biden ultimately picks to succeed Randal Quarles, the departing central bank governor who served as its regulatory point man until last month.

Mr. Powell has said he would defer to whoever fills that role in setting the central bank’s approach to regulation. 

Mr. Biden said on Monday that he would soon nominate a new supervisory chief.

“I respect that that’s the person who will set the regulatory agenda going forward,” Mr. Powell told reporters in September. 

“It’s fully appropriate to look at—for a new person to come in and look at the current state of regulation and supervision and suggest appropriate changes.”

Departing governor Randal Quarles served as the Fed’s regulatory point man until last month. / PHOTO: KYLE GRILLOT/BLOOMBERG NEWS

During Mr. Powell’s nearly four years as head of the Fed, the central bank has revamped big-bank stress tests, including eliminating pass-fail grades, tailored its rules for U.S. lenders based on their size, and simplified key postcrisis regulations such as the Volcker rule prohibition on proprietary trading.

Mr. Powell and supporters of those changes have referred to them as a tailoring of complex rules. 

Some Democratic critics say that the changes, while each modest individually, have in their totality substantially weakened the original overhauls.

Ms. Brainard, an important ally of Mr. Powell on monetary policy, has regularly dissented from his decisions to ease bank regulations enacted after the 2008-09 financial crisis. 

Ms. Brainard has said generally that the Fed’s moves to soften regulations have gone too far. 

If confirmed as vice chairman of the Fed board, Ms. Brainard would have a vote on regulatory matters before the central bank but wouldn’t set its regulatory agenda.

Industry officials welcomed Monday’s Fed nominations.

“We expect regulators will continue to hold the largest banks to the high regulatory and supervisory standards that have remained in place to support a resilient and essential part of the U.S. financial system,” Kevin Fromer, chief executive officer of the Financial Services Forum, which represents the largest U.S. banks, said in a written statement.

In addition to the Fed vacancies, several top financial posts remain unfilled. 

These include vice chairman at the Federal Deposit Insurance Corp. and a full-time director for the Federal Housing Finance Agency, which oversees government-controlled mortgage giants Fannie Mae and Freddie Mac.

Saule Omarova, Mr. Biden’s nominee to head the Office of the Comptroller of the Currency, which oversees national banks, faced bipartisan skepticism at a hearing last week and faces an uncertain path to confirmation. 

Another nominee, Rostin Behnam, is awaiting confirmation to head the Commodity Futures Trading Commission, the top U.S. derivatives overseer. 

Mr. Behnam currently serves as the CFTC’s acting chairman.

Gary Gensler, who as Mr. Biden’s Securities and Exchange Commission chairman has outlined an aggressive agenda that threatens to squeeze the financial industry’s profit margins, was confirmed in April. 

Rohit Chopra, a former adviser to Sen. Elizabeth Warren (D., Mass.) and Mr. Biden’s pick to head the Consumer Financial Protection Agency, was confirmed Sept. 30.

If Mr. Powell and Ms. Brainard win Senate approval for their posts, three openings would remain on the Fed’s seven member board: the position of vice chairman for supervision and two separate governors’ seats.

Lael Brainard, who was nominated as Fed vice chairman on Monday, has regularly dissented from Mr. Powell’s decisions to ease bank regulations. / PHOTO: AL DRAGO/BLOOMBERG NEWS

The Fed’s recomposed board will be tasked with approving or denying a bevy of bank deals announced over the past year. 

Bank mergers and acquisitions are on pace in 2021 for their biggest year since at least 2008, when some large banks were forced to sell in the face of collapse.

The vice chairman for supervision could spearhead a review of the central bank’s framework for reviewing bank deals. 

That approach is more likely if the nominee shares Ms. Brainard’s view that the Fed should more closely scrutinize bank mergers.

“The Fed probably just won’t be in a huge rush to approve mergers until the new nominees get settled and kind of develop a strategy on what they want to do on bank mergers,” said Jeremy Kress, an assistant professor of business law at the University of Michigan who researches financial regulation.

Mr. Biden in July issued an executive order asking bank regulators and the Justice Department to deliver “more robust scrutiny” of bank deals.

Also on the Fed’s regulatory agenda is what steps should be taken to address financial risks posed by climate change, the level of regulation needed around cryptocurrencies and how banks should treat Treasurys and deposits they hold at the central bank.

Today’s Shortages Could Soon Become Tomorrow's Gluts

History suggests that acute shortages can lead to overproduction, eventually bringing down prices

By Justin Lahart

Bottlenecks like at the Port of Los Angeles have contributed to supply-chain problems, leading to higher prices. / PHOTO: BING GUAN/BLOOMBERG NEWS

In the throes of the sticker shock many Americans have been experiencing lately, it is hard to remember an oft-repeated lesson: Shortages can suddenly turn into gluts.

The combination of bottlenecks and robust demand has pushed prices for all kinds of things higher, but some of the most eye-popping increases have been in the prices of manufactured goods that rely on global supply chains. 

The October consumer inflation report from the Labor Department showed prices for washers and dryers were up 30.1% last month from the pandemic’s start, with prices for furniture up 12% and prices for new cars and trucks up 11.3%.

Further, shortages of some manufactured items are creating inflation elsewhere. 

The dearth of new vehicles has made it hard for rental-car companies to restock their fleets, which is a big part of why it cost 49.2% more to rent a car or truck in October than before the pandemic. 

Fewer new car purchases by rental companies in particular has led to fewer available used cars, and used car and truck prices have risen 44%.

For a lot of people, the argument that these price increases are transitory has worn thin. 

Policy makers and economists were saying that supply-chain problems would be starting to ease this fall, and now they are expected to persist until next year. 

With inventories low and what appears to be a lot of unsated demand out there, it is easy to imagine prices continuing to go up.

But imagining that supply-demand imbalances will persist, and then finding that they won’t, is a common occurrence. 

Pig breeders and cattle ranchers have regularly responded to high prices with production increases that initially aggravate shortages but then lead to gluts in the so-called hog and cattle cycles that drive huge swings in pork and beef prices. 

A similar dynamic occurs in shipping costs, and ship prices. 

And back in May, when prices were surging, it didn’t seem as if framing-lumber prices were going to fall by more than half—but then they did.

Retailers such as Target say they are well stocked for Black Friday. / PHOTO: BRANDON BELL/GETTY IMAGES

In the year ahead, even slight relief of some supply-chain issues could have significant effects. 

For example, there are a lot of partially built vehicles that car makers have parked around the country which will be rolling into dealerships once necessary chips are installed. 

In a recent note, the Bank for International Settlements pointed out that the building of precautionary stockpiles of components by some manufacturers might be exacerbating shortages—a phenomenon that might also paint a false picture of underlying demand. 

Earlier this fall, many retailers were imploring consumers to get their holiday shopping done early, lest supplies run out, yet last week Walmart, Target and TJX all said they are well stocked for Black Friday.

Another place inventories might be higher than readily perceived is in people’s homes and driveways. 

Adjusted for inflation, consumer purchases of durable goods—long-lasting items including bicycles and television sets—rose 7.7% last year from 2019, and in the first nine months of this year were up 26.6% versus two years ago. 

Even pent-up consumer demand for new cars might be less than seems apparent: While production problems have pushed new car and truck sales well below their 2019 levels this year, exclude fleet sales to rental companies and the like, and they are only down a bit.

If Covid-19 risks continue to diminish in the months ahead, allowing people to resume more of their pre-pandemic activities, more spending might be shifted away from goods toward services. 

Lower Covid-19 risks would also help alleviate some supply-chain snarls, especially in countries outside the U.S. that are major sources of manufactured goods and components. 

At the least, prices for some items could stop rising and become drags on inflation. 

And prices for some goods, such as used cars—which have accounted for about a percentage point of the 6.9% increase in overall consumer prices—could fall.

By this time next year, inflation might not seem like nearly as big a problem as it does right now.