Inflation Fears Are Overblown 17 comments
Eric Parnell
About this author:
-
Font Size:
-
Print
- TweetThis
Inflation fears have been weighing heavily on investment markets. At first glance, these concerns seem well founded. After all, prices for gasoline at the pump and food at the grocery store have skyrocketed. The chronically weak U.S. dollar is also adding fuel to the fire, as it makes the cost of imported goods more expensive. And the U.S. Federal Reserve has pitched in too by lowering interest rates aggressively over the last year from 5.25% to 2.00% in response to the weakening economy and the global credit crisis, as these rates cuts are working to put more money in the hands of businesses and consumers to help increase their demand to buy new products. Despite these influences, a closer examination of the situation reveals that the inflation threat to the U.S. economy is actually fairly limited at present, which should eventually be good news for both equity and fixed income investors going forward.
The inflation problem is far more concentrated than it first appears. Looking beyond food and energy, the rate of increase in prices across the broader economy is actually rather subdued. In addition, many segments are actually enduring an extended bout of deflation. For example, many furniture and clothing retailers have been offering fairly aggressively discounts in order to move merchandise from their stores. And one can go out today and purchase a new car for less than what they paid for a comparable new model back in 2003. So while some items we are buying today are significantly more expensive, other items are actually becoming meaningfully less expensive.
Housing also greatly distorts our perception of inflation. A fact that is often ignored but is fairly relevant is the estimation of housing costs in building out the monthly Consumer Price Index [CPI], which is a key U.S. inflation reading. The cost of shelter makes up roughly 30% of the CPI, but this cost is determined by estimating how much it costs to rent a property, not how much it costs to buy a home. So even though home prices have fallen by nearly -30% as measured by the Case-Shiller Home Price Index, the cost of shelter component in the CPI has actually been rising modestly since property rental costs have stayed fairly steady. As a result, if one were to substitute the actual change in housing prices into the CPI calculation, the U.S. inflation rate would turn decisively negative and the dialog would likely shift away from concerns about inflation to much greater worries about deflation.
Several factors should help keep remaining inflation pressures in check going forward. Although the recent rise in inflation is generally concentrated in a small basket of items such as food and energy, the magnitude of recent price increases has still been extreme. Just as significantly, it is reasonable to wonder whether these isolated inflationary pressures might soon spread across other pricing segments. Several factors suggest, however, that these pricing risks should not accelerate but instead should soon subside.
First, wage growth is virtually non-existent. Wage growth is a critical element to support an inflation outbreak, as consumers need to make more money in order to keep spending and subsequently push prices higher. However, workers in the U.S. are not seeing much of an increase in their paychecks and are actually taking a pay cut once inflation is included into the mix (see chart). In addition, since many companies are currently in the process laying people off, those employees that remain are probably less inclined to ask their boss for a raise and are likely more content to simply hang onto their job for now. This should help keep wage growth in check in the months ahead.
click to enlarge
Second, without wage growth, higher energy and food prices have a deflationary effect. Most people are not getting pay increases at their jobs. However, they still have to spend more money on gasoline and food. As a result, once they have filled their cars with gas and their cupboards with food, they end up having less money than before left over to spend on other goods such as clothing, computers, washing machines and cars. This means that consumers will likely cut back spending on these less essential items, which would increase the discounting activity by retailers for these products. Thus, higher oil and food prices end up serving as a deflationary tax on consumers instead of an inflationary spark.
Third, increased globalization and declining economic growth are limiting pricing power. The global economy has become increasingly competitive as trade barriers continue to fall, international markets become more integrated and emerging markets become more developed. Because of this evolution, U.S. companies in many industries have far less flexibility to raise prices, as they run the risk of losing market share to global competitors. This is particularly true in the currently weak economic environment, as belt-tightening businesses and consumers are far more price conscious. As a result, many companies have instead focused on lowering costs and increasing operational efficiencies to maintain margins.
Finally, any reversal in the direction of oil and food prices would be deflationary. Many investors believe that oil prices have been driven to current levels by speculative froth. If oil prices were to suddenly drop toward $100 a barrel, this would represent a –25% decline in a key component that has been driving the headline inflation rate up over the last several years. The same idea holds true for food prices. As a result, any drop off or at minimum leveling in the prices of these two key commodities would also help to cool inflation concerns.
Stock and bond markets should benefit assuming recent inflation concerns subside. After reaching a short-term peak in mid-May, the recent inflation threat has caused stocks to retrace their way back toward March lows, as investors are concerned that the U.S. Federal Reserve may be forced to raise rates sooner rather than later. This has also weighed on the bond market, as 10-year Treasury yields have leapt from below 3.8% to above 4.1% in recent weeks. If the inflation threat fades along with the decelerating global economy as expected in the months ahead, this would push back rising interest rate expectations from the Fed and turn a headwind into a tailwind for both stocks and bonds.
While inflation risks may stay contained for now, pricing risks remain on the horizon. Considerable inflation pressures have taken hold in many economies outside of the U.S., particularly among emerging economies that are net exporters of oil, mining and agriculture commodities. Once growth in the developed world begins to reaccelerate perhaps sometime next year, a global inflation outbreak may surface as a major issue to address. It is worth noting that much has to fall into place between now and then for this outcome to occur, but it merits monitoring in the months ahead nonetheless.
Conclusion: Current inflation concerns are overblown, and potential relief on the pricing front in the months ahead should eventually help support equity and fixed income upside.
Full Disclosures: No Long or Short positions in any equity or fixed income ETFs.
Related Articles
|
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largestSee all
increase in followers
in the last 7 days
Fastest Climbers » -
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most active
Instabloggers.-
1
TraderMark
-
2
Don Dion
-
3
Cliff Wachtel
-
4
Mike Havrilla
-
5
James Quinn
Top Instabloggers » -
1
-
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
This article has 17 comments:
However, future inflation is a concern.
however, a decelerating economy and fears of deflation would certainly not be good for equities ?
That would only be proper if the CPI had included "the actual change in housing prices" while they were on the way up. You can't exclude them when rising and then include them when falling. Had they always been included, the price inflation picture over the last ten years would be significantly different. And not pretty.
You also said: "Thus, higher oil and food prices end up serving as a deflationary tax on consumers instead of an inflationary spark." Then you went on to say: "Finally, any reversal in the direction of oil and food prices would be deflationary."
Well, which is it?
Businesses get caught with too much inventory and must clear it out at reduced prices.
But once that excess old stock is gone, the next purchase of inventory will be at higher prices. They cannot sell the higher cost inventory for same price as the old stock they just sold through. So either the prices rise of they sell everything at a loss...
The inputs to production have risen (new price of iron ore is 100% higher than last year) and that will lead to the price of outputs of production increasing as we go forward.
We'll have lower wages and higher prices across the board a year from now.
The odds are that no matter how one dresses it up, the US economy will be an ugly pig for some time. And it's just gonna get uglier. If nothing else, panicky consumers losing their jobs and struggling to pay for gas will make that a self-fulfilling prophecy.
Just watch.
Thanks to the author
By the same token, when money disappears from the economy, that is deflation and one possible outcome is lower prices. When stock markets and real estate markets lose value, that money disappears from the economy and the economy deflates.
This is the majority view of the Fed, of Bernanke, or many Wall Street firms, and of the vast majority of media reporting. Then, the author goes onto repeat this mainstream consensus view as somehow contrarian.
In fact, almost everything the author says is incorrect. The contrarian view is that money supply growth has exploded and that inflation going forward will be much worse. This is not reported in the mainstream media, and isn't even acknowledged as a possibility by the fed.
The facts that the author uses to suport his claims are mostly either irrelevant, or incorrect. For example, lack of wage growth is real, but is not necessary for inflation. Wages can rise with very little inflation, and wages can fall in real terms (as they are now) with real substantial increases in inflation.
Globalization is keeping wage growth in check, but global money supply growth is causing global inflation.
Those who think for themselves and care to dig deeply into the numbers, and arent afraid to go very far out against the herd will see that stagflation is a real phenomenon that is likely here, and liikely to get worse. Real inflation is much more than twice what the government reports.
I think if you look at the global situation inflation seems to be taking root around the world. I am not sure of the manner it is happening (not that smart) but it looks to me as if we are exporting our inflation to the emerging markets somehow. Any rocket scientists wish to comment on this idea?
I think the deflationary issue is interesting. If I look at what is happening we have clear inflation in the commodity sector (inputs) but many manufacturing businesses or ones that are capitally intensive are saying that they cannot pass those costs along. So..this means to me that there is only one place that they can come from and that is profits.
That indicates to me that many stock prices are going DOWN. The exception will be the (non financial ) service sector which will be more impacted from wage increases which the article correctly states are stagnant at best. Then we also have the downward trend in housing (which maybe just maybe ) we are seeing some slowing in the rate of decline.
Put it all together and what we need is the "Goldilocks's FED." I am not sure they have it in them but we are on a tight rope that many people do not even seem to understand we are on.
I also agree with Eric Hart: this piece is very mainstream as far as the pundits, academics, and monetary policymakers go. And I would argue that until oil recently proved it could hold above $110/barrel or so, the vast majority of talk we heard in the media pooh-poohed inflationary threats, mainly because the Fed told us so. One thing we used to hear was that surely oil would go back down to $70, $80, etc...
In the end, it's the expectations that count most. Oil and food inflation are driving expectations for future inflation ever upward. And, eventually, yes, labor will begin protesting for higher wages once it really sinks in that counting on credit cards and home equity will no longer support current living standards. The wage story is probably the last leg of the "inflation is no threat" stool.
Finally, I am curious to find out where that chart came from showing real wage growth? I often here pundits who claim the economy has been and is just fine say that wage growth has been healthy. It never made sense to me, and I have been looking for the real data in a clear and understandable form.