Services PMI: Inflation Gates Remain Shut

You know what the best way to predict a company’s decision is?

See how much they’re paying to play.

Right now, Service companies report their respective prices paid to be at the 93rd percentile since 1997!

Meaning,

Services inflation is near a historical record, and most companies are not able to operate this way for long, unless they have the size or financing abilities of some of the largest AI names in the market today.

After breaking down what the manufacturing sector had to say about the market last week…

It’s time to check on the services economy, and find out who (if anyone) is still managing to turn a profit when prices paid are this high.

As it turns out, there are three cost items that will keep both 10-year bond yields and CPI inflation higher for longer.

But that doesn’t mean everyone loses.

In fact, there are two industries that really carried their weight in expansion beyond just pull-forward demand (buying now before prices go up.)

The funny thing is,

Markets are already beginning to place these industries at a premium due to controlled pricing inputs and organic demand increases.

So, I dug deeper into them and found a new set of stocks to add to my watchlist just like I did from last week’s manufacturing PMI report.

Click here to access the watchlist.

Today, we’ll go over what those industries are and how they will most likely deliver an outperformance relative to the rest of the market in the coming months.

Let’s get into it,

Services PMI: Inflation gates remain shut.

Like the Manufacturing PMI theme, the Services economy is now going through an input cost pain point that shows up in selective areas.

Which leads capital to only a few industries which carry the following characteristics:

That’s similar to the setups we hunted for last week in the manufacturing breakdown.

With a bit of nuance…

Commodities short in stock are nowhere near where they were last quarter, and the ones that did go up in price/shortages were all fuel related.

One massively important piece of information.

Everyone is trying to sell you on the idea that AI-related commodities and products are in a terrible shortage, and that the companies making these products will reach multi-trillion-dollar valuations because they provide these products.

Not the case,

Every executive in the services sector (~80% of the U.S. economy) mentioned fuel and tariffs a their main concern for pricing instability.

Zero mentioned AI or data centers as a negative constraint to supply or productivity.

The same reasoning was demonstrated by the manufacturing PMI and the latest PCE inflation numbers.

Speaking of which:

Prices paid by ~80% of the economy’s businesses represent the majority of the moves made in the month-to-month PCE inflation figures.

Which right now suggest inflation could trend toward 3.8% again over the next six months.

Just another reason to expect the 10-year bond yield to stay above 5% for longer, worsened by the term premiums still trending higher on further fiscal and economic uncertainty.

Click here to understand why term premiums continue to drive bond yields higher.

Here is where understanding this inflation trend becomes important…

Consumers and other businesses are pulling their orders forward (just as they did for manufacturing PMI industries) so they can lock in a lower price today.

All else equal,

Companies with rising backlogs and an ability to pass down costs to these buyers will begin hiring more personnel in order to fulfill on these rising backlogs.

We spot those who are hiring, and we can determine where the future positive returns will be with a high degree of confidence.

42% of the changes in ISM employment can be explained by where the NFP report goes.

The rest can be explained by the quarterly trends in backlogs vs actual services employment (on the right.)

When we dig into the latest NFP trends, zooming in by industry, it becomes clear only three areas of the economy are hiring right now on these increased backlogs:

Consequently, these are also the industries with the best ability to pass down costs immediately without seeing much of a decline in demand volumes.

Therefore, these are the areas I am most interested in digging into for ideas.

If you recall from the manufacturing PMI breakdown, this also connects to the breakouts in wood products, airlines, and food items.

Confirmations are becoming clear all around at this point, and extending our current watchlist looks like an easier task.

However,

This is where we begin to get priorities straight as far as which industries deserve our attention first.

Transportation, Wholesale Trade, and Real Estate.

These are the ones leading the composite scores, which give a pretty high probability of positive one-month returns from here.

Construction, while being one of the big hirers and able to pass down costs, did not expand on this score.

Once again, as seen in manufacturing…

Housing is a coiled spring, and will remain so as long as mortgage rates (through the 10-year bond yield) stay this high.

But,

The moment rates come down even slightly, there is enough economic activity building up now to send the entire sector much higher from here.

Here’s a more specific view on this priority list:

On a quarterly momentum basis, it’s clear that wholesale and real estate are the best areas to focus on right now.

Wholesale trade is directly connected to food items in the manufacturing PMI, and so is it to transportation when it comes to trucking and freight.

Which acts as another green check for me to continue digging on those ideas and expand the watchlist.

I believe at this point the selection has narrowed down significantly:

So the moment rates and fuel costs go down, all the names we’ll be selecting from here have the highest odds of breaking out significantly.

Which explains why the market is now paying premium forward P/Es for them!

One of the names in food items from our watchlist is ready to take off.

Click here to access the watchlist and keep this name on top of your queue.

I say this as I watch the order flow get hit with buy order after buy order…

But more importantly,

I say it because wholesale inventories are even lower than in COVID times, with a rising composite score to point us straight into production activity at higher margins.

Perfect for EPS beating quarterly expectations.

You can already see these effects in how food service stocks have traded this year (up ~30%) while the so-called AI bottlenecks in electrical & building equipment underperform the S&P 500.

This is why knowing how to read the data matters.

Now that we know wholesale trade is about to take off.

It’s time to understand transportation’s role in this breakout.

Cass shipments are spiking along with the transport ISM composite score.

Which makes absolute sense, as most of this activity is rooted and connected to the rise in wholesale momentum.

But,

Who really benefits in transportation?

We know airlines and food services are the most affected by higher diesel prices, so we know where to look the moment fuel costs normalize.

Understanding that wholesale products travel mostly by air and truck shipping, I would even expand my search to these areas.

Therefore:

Are now part of my watchlist of ideas corroborated by manufacturing and services PMI data.

Here is where things begin to diverge for real estate.

Because there is no construction activity taking off right now (due to the constraint in yields and mortgages) most of the real estate activity happening right now is found in leasing.

If people can’t buy, they’ll still have to rent a place.

Then we have the leasing of commercial property which is entirely centered around data centers that begin to hit the market after construction started several months ago.

On an exposure to yields view,

Homebuilders, housing services, and REITs are the most exposed.

That expands the areas of interest where I will be digging for potential trade ideas.

To be honest with you, and let this serve as a footnote for where my mind is at…

I am very interested in building a portfolio of a handful of residential REITs at this point.

Why?

Both of which are factors that can lead to a satisfactory outcome in this housing recovery theme.

More on that portfolio later inside Offside Premium.

From GDP, and now in the PMI, I will reiterate the same trade I spotted in the options market earlier in the week.

We will now have to consider the options activity around some of these coiled springs.

I have found an interesting setup in the Builders FirstSource (BLDR) ticker here:

There is a good amount of betting that BLDR will see a massive rally by January 2028, to the tune of ~$192 per share.

Those long calls seem to be funded on a 2:1 ratio by shorting monthly puts for $57 strikes, which is close to where the stock sits today.

Mechanics are simple here…

Dealers will make monthly premiums to pay for their long $192 call strike position into next year, and reduce their timing and movement risk while at it.

It’s the same trade I have on for memory stocks, just betting on the opposite direction.

When you piece it all together,

It’s clear the market has already predicted and digested today’s GDP print, but us mortals are left to figure it out like we did today.

Open this again in 6-9 months and tell me I’m wrong.

Meanwhile, here is the latest from the Maverick of Wall Street covering the geopolitical situation in Europe, the U.S. and other bond markets.

As we know,

Most of the coiled springs we are looking to buy and hit a few doubles or triples heavily rely on where the 10-year bond yield goes next, so keep this one handy:

Until next time,

OFFSIDE RESEARCH

Against the Tape, Ahead of the Curve.