March 2005
The financial markets were a bit spooked last month by January's report on inflation for wholesale prices. However, soon after, nerves were calmed when it was shown that prices at the consumer level still looked pretty tame. After many years of investing in an environment of declining inflation rates, we think that rising inflation could surprise investors in the not so distant future.
Campbell Soup Company is doing it. So are Hershey's and General Mills. The fact is there are reports in the financial press almost every week that other companies are doing it too. What are they doing? They are raising prices even with the competition breathing down their necks.
With average consumer price increases rising but still below 3.0%, many investors still don't seem to be concerned about the inflationary implications of these announcements. We think that could be a mistake. Higher inflation has never been good for the stock or bond markets so we will take this recent whiff of inflation seriously and watch out for indications of more to come.
Investors have not had to contend with a rising trend of inflation in a very long time. In fact, investors less than 50 years old only remember investing during the 1980's and 90's when inflation was falling. Predictably, financial assets flourished in those years as interest rates fell and price/earnings ratios rose.
Inflation seemed to almost disappear during and after the last recession because of the overexpansion by Corporate America in the late 1990's. Companies responded to the strong economy and cheap capital to create more capacity than was needed to satisfy the demand for their goods. The oversupplied situation was made worse by growing competition from overseas, especially from low cost, developing countries like China and India. Raising prices to cover higher costs was simply not an option for most companies selling to consumers because their customers had other alternatives. In fact, the Internet made it very easy for customers to compare prices among competing companies. It was a real challenge for many to just maintain prices.
With advances in technology, businesses have been able to increase their profits by finding ways to be more productive and better at controlling costs. Holding back on hiring and getting more work out of each employee has been the mantra of most corporations. However, that may now be changing.
We think managers are beginning to realize that there are limits to using productivity enhancements to increase profitability or to cover the continually rising energy and healthcare costs. At some point prices have to be raised and that is what more and more companies are beginning to do. And if those price hikes stick, they will be inclined to do it again in the future.
In their effort to prevent the deflationary forces from Asia from hitting our shores, the Federal Reserve has inadvertently created a more hospitable environment for inflation. They have been very generous supplying dollars to the global economy. In fact, their generosity has been a major reason for the weakening U.S. dollar. In turn, the weakening dollar has caused import prices to rise, which gives U.S. producers an opportunity to match those price increases of their foreign competitors. Inflation rates normally rise following periods when the money supply has been growing faster than the economy and the value of the dollar has been declining.
Recent reports from the Labor Department concerning producer (wholesale) and consumer prices for the month of January confirmed the possibility for higher inflation in the future. They showed that not only were "core" consumer prices (not counting food and energy) rising faster than last year but producer prices were increasing at an even faster rate. Simply put, this means that companies selling to retail customers are continuing to have to deal with cost pressures from their suppliers and more of them are going to have to raise prices to protect and increase their profits. While both the bond and stock markets sold off on the news, equity investors regained confidence and the stock market recovered as they rationalized that 2.3% core inflation was not all that bad.
We do not want to be accused of being like Chicken Little and suggesting that inflation is going to come roaring back soon. However, combining market history and our desire to protect our clients' money and earn a decent return we think it is prudent to keep a close eye on the inflation trends. Inflationary environments are typically not very good for investment returns.
It is easy to understand why higher inflation is negative for bond investors. Bond investors receive a fixed coupon income return for the time their money is invested and when the bond matures they get their money back. Higher inflation reduces the purchasing power of both their income payments and their money invested in the bond. That is precisely why in high inflationary years of the 1970's bonds were called the "confiscators of wealth".
Studies show that there is a strong correlation between inflation trends and stock market returns. Average equity market returns diminish rapidly with higher levels of inflation momentum. The worst environment for stocks is when inflation accelerates too quickly.
During the 70 years of S&P 500 history, the index lost an average of 7% in years when inflation accelerated by more than 1%. It should be noted, however, that the stock market has shown to be very tolerant of small rises in inflation. In fact, on average, the market was able to generate a high single-digit return when the increase in inflation was less than 1%.
Rising inflation is bad news for stocks because it is normally accompanied by higher interest rates, which generally reduce price/earnings multiples. Research by Bear Stearns suggests that a 0.5% rise in today's bond rates could cause the stock market's P/E ratio to fall by a full point. And this would happen at a time when corporate earnings growth rates are declining. That is not a good combination for investors.
As of the end of 2004 the inflation rate was 0.6% higher than the prior year and if the consumer price indices continue to show an increase in inflation, it will not be good for stocks. And for bonds...forget about it. That is why we pay close attention to even a whiff of inflation.
John W. Gudritz, CFA
john@frontstreet.com