Good Spring Data May Contain Seeds Of Inflation

by: Jim Kelleher


With the economy humming and interest rates set to rise, long-dormant inflation fears are bubbling up.

Since the early February low, two-thirds of the best-performing S&P 500 industry groups come from Energy, Materials, and Industrials.

A little inflation can be a good thing for stocks, as it grants companies pricing power that they can lever into top-line growth, operating leverage, margin expansion, and rising earnings.

Surveying U.S. economic data released since April 1, we are hard-pressed to find a data point that is not strong and above-consensus. The Fed remains on its tapering time-line, with QE likely to expire this fall, and all signs point to more restrictive Fed policy beginning in mid-2015. With the economy humming and interest rates set to rise, long-dormant inflation fears are bubbling up. Stock market leadership is already shifting toward inflation beneficiaries. We would keep apprised of trends in pricing, which if overheated can signal trouble ahead for stocks - though likely not this year.

Nary a Bad Data Point

Coincident with the crack of bat on ball that signals the start of the Major League Baseball season, the economic data since the beginning of April has been one home run after another. In the first two weeks of the month, when frigid mornings kept the echoes of winter alive, investors expected data from the first quarter to be soft and weather-impacted.

Instead, the month started with a stronger than consensus ISM Manufacturing reading of 54.0 for March. ISM Prices Paid was elevated at 59.0, consistent with February's 60.0 reading and a nascent sign that companies were seeking and getting pricing power in the market place. Total Vehicle sales came in at a 16.3 million SAAR for March, trouncing the 15.8 million consensus call and the 15.2 million SAAR in the prior month - and putting to rest the view that March was too snowy to visit Auto Dealer Showrooms. In a lagged release that provided an unexpected prism on the winter-time economy, Factory orders soared 1.6% in February.

Challenger's measure of job cuts is a data series loved by economists and ignored by the public. In March, according to Challenger, job cuts were down 30% year over year; companies are apparently too busy to lay anyone off. Continuing unemployment claims ratcheted down again early in April, dropping to 2.84 million. The other side of the jobs equation, hiring, was equally positive, as March nonfarm payrolls rose 192,000 and prior months were revised up.

Little remarked amid jobs jubilation was the 2.1% annual rise in average hourly earnings. That number was low on the historical scale; yet since the recession, the annual change in hourly earnings has only recently surpassed the 2% level. Wage growth in the low 2% range is not inflationary on its own, but coupled with other data it can contribute to pricing pressure.

For our money, one of the more surprising data points was from the National Federation of Independent Businesses (NFIB). Small business people tend to be a cautious, and the NFIB's Small Business Optimism index - which ran above 100 for most of 1994 through 20007 - dipped to 80 during the recession and has mostly remained in the 80s ever since. Only recently has this survey regained the 93-94 level that represents the median value since 1986. The NFIB Small Business Optimism reading of 93.4 for March was up 200 basis points from February and is now sitting right on that multi-decade median. Within a wealth of accompanying data, NFIB reported an 8% increase in percentage of owners raising selling prices - another "green shoot" of inflation buried in the details.

Price Creep

The data point that really got us thinking about inflation was the 0.5% month-over-month rise in all-items producer prices, which blew out the consensus forecast of a 0.1% decline. The Labor Department is now including more services data along with hard-goods inputs, and that may have contributed to the cost spike. Still, the services gains were in areas - retail clothing and jewelry, along with food wholesalers - suggesting that businesses are adapting to a retail environment where consumers are comfortable spending again.

That point was driven home by the stronger-than-anticipated 1.1% jump in March retail sales, the sturdiest gain since 2012. February retail sales were revised up to 0.7% growth from a preliminary 0.3% reading. Among the 13 retail sales categories measured by the Commerce Department, 10 categories showed rising sales in March.

One factor that may be contributing to increasing consumer willingness to spend: producer price hikes have not yet been fully passed down to the retail level. March's consumer price index was up 0.2% on both an all-items basis and excluding food and energy. Still, it is worth noting that the 0.2% monthly gain doubled the 0.1% gains recorded in recent months. And the annual rate of change in CPI has now crept up to 1.5%, after running in the 1.1% range in February.

Industrial production rose a higher than forecast 0.7% in March, on top of an upwardly revised 1.2% rise in February. Utility output along with higher mining and energy production contributed to the strong two-month trend. Separately, factory production increased 0.5% in March after rising an upwardly revised 1.5% in February - the strongest increase in this series in four years.

The jump in industrial production pushed capacity utilization to 79.2%, which is its long-term (35-year) average. According to Argus Chief Investment Strategist Peter Canelo, when capacity utilization is above the 79.2% median, inflation tends to run 130 basis points higher than when capacity utilization is below the median.

Data across the balance of April has contributed to the picture of a strengthening domestic economy - and also one in which prices are rising. Three regional diffusion surveys - from the Federal Reserve banks of Philadelphia, Chicago, and Richmond - all exceeded expectations. The Leading Economic Indicators (LEI) index jumped 0.8% in March, and is up 6.1% over the past 12 months - the strongest annual rate of change since 2011. Six of 10 categories in the LEI advanced month over month, led by interest rate spreads, the drop in jobless claims, and increasing length of the factory workweek.

The U.S. Federal Housing Finance Agency (FHFA) reports that housing prices nationwide rose 6.9% year over year in the latest survey month. Home price appreciation has backed down from the low double-digit gains of the past year, but still signals rising costs to acquire a home. Within the CPI data released mid-month, owners equivalent rent increased 2.7% year over year - the biggest gain since 2008.

What the Stock Market Thinks

Within the U.S. stock market, year to date performance shows some familiar sectors leading in 2014 much as they led in recent years, based on carry-over momentum from 2013 in 1Q14. But trend change in the past one-two months show that investors are anticipating a different market environment ahead.

During 2Q14, the change in sector leadership has been dramatic. The two leading sectors of recent years, consumer discretionary and healthcare, are relatively underperforming. Consumer Discretionary has actually been lagging all year. Using iShares Dow Jones ETFs, Energy is the second-quarter leader (up 4%) followed by Materials and Energy (each up approximately 1%).

Chief Investment Strategist Canelo notes that since the early February low, two-thirds of the best-performing S&P 500 industry groups come from Energy, Materials, and Industrials. Market-leading industry groups include five industrial sub-sectors and three sub-sectors each from energy and materials. When investors worry about inflation, they invest in "wealth in the ground" assets in these sectors. A glance at the Commodity Research Bureau's Continuous Commodity Index (NYSE:CCI) chart shows dramatic upward movement: from the low 500s prevailing in fall 2013 into winter 2014, to the 560s level prevailing since mid-March.


The clear acceleration in economic activity seems to be translating into higher prices, in our view. If you have been waiting for a roaring economy to invest in stocks, now is your time. But keep in mind that a roaring economy is more likely to be associated with the end of a stock market rally than the beginning - and that is most often because inflation is not far behind.

The trend in pricing is not yet ominous, and it may never become ominous; but it bears watching. A little inflation can be a good thing for stocks, as it grants companies pricing power that they can lever into top-line growth, operating leverage, margin expansion, and rising earnings.

But high levels of inflation are associated with stagnant and/or declining stock markets. While we do not expect pricing trends to become too worrisome this year, price levels in an accelerating economy always require vigilance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.