Margins resilient, risks tilted to the upside near-term As the debate about inflation heats up, we do a deep dive on corporate pricing power and assess the crosscurrents impacting margins, quantifying upside and downside risks.

Cost pressures are rising due to commodity prices, supply chain constraints and wages.

However, we believe the impact is fairly concentrated and the S&P 500 should be able to more than offset these headwinds through other major drivers: - Tailwinds: Elevated operating leverage (3x for S&P 500), strong pricing power (corporate pricing should accelerate 100bp+ near-term), cost efficiencies (5% reduction in automatable costs could boost margins ~60bps) and a possible fall in rental expense (accounts for 3% of total costs) are all supportive drivers for profit margins.

- Headwinds: Cost pressures are emerging but the impact may not be as big as feared.

Key factors to watch include rising commodity costs (which account for 5% of costs), accelerating wage growth (2ppt further rise could be ~30bps margin hit) and shipping/ transportation costs (limited exposure at ~0.7% of total costs). Taxes will also be important as the Biden/Dem proposed plans could reduce net margins by ~90bps.

A framework for quantifying corporate pricing power, three stock screens We developed a framework for scoring corporate pricing power at the stock level which is built around three pillars. To request the full data on pricing power factors for stocks in the S&P 1500 click here.

- 1. Pricing power: We use a differentiated approach to quantify pricing power by calculating a firm's markup - the extent to which a company can raise prices over and above costs. We combine this with other margin strength and market power metrics.

- 2. Margin momentum: Margin momentum tends to persist. We track corporate pricing trends using our proprietary pricing mapping. Firms with greater analyst margin revisions and sales growth acceleration with lower margin expectations also score better.

- 3. Input cost exposure: Using UBS Evidence Lab's Deep Theme Explorer, we search for companies with negative sentiment around commodity and transport costs on earnings calls. We also calculate the sensitivity of corporate earnings to wage growth.

- Three stock screens: We highlight a large cap and SMID cap screen of companies with the highest pricing power and margin momentum as well as a screen of stocks with the weakest pricing power and higher input cost exposures.

- Margin scorecard: We create a weighted score based on the factors above to assess sector and industry pricing power. Media & Entertainment, Software & Services, and Household Products rank best. Industrials and Utilities rank worst.

Strong pricing power stocks are set to outperform The current backdrop of rising inflation should help companies with strong pricing power outperform. This relative strength does not appear to be priced in. Since October 2020, strong pricing power stocks have underperformed weak ones by ~10%, and on a 2y fwd relative P/E basis trade 7% below their average since 2010.

- Higher inflation periods: When 6m annualized CPI has exceeded 3%, as is the case currently, strong pricing power stocks have outperformed weak ones by ~12% in the subsequent 12mo. Thus, we look to move up in quality into better pricing power stocks.

- Economic cycle phase: Strong pricing power stocks have their best relative run during the late recovery/expansion phase of economic cycles when the ISM is high but falling.

- Consistent margin expansion: Strong pricing power stocks have consistently expanded EBIT margins, averaging a 45bps rise in the following year and 65bp more than weak pricing firms. Yet the consensus expects weak pricing power firms to deliver higher margins gains in both '21 and '22, which has only happened once since '10.