After being forgotten for most of the market cycle, inflation is quickly becoming a popular topic and growing risk for investors. Recent CPI and PPI reports raised concerns further. It’s uncertain if government reports will continue to show an acceleration in prices; however, I’m increasingly confident of what businesses are experiencing. Based on my bottom-up analysis, inflation is in the pipeline and the upward trend remains uninterrupted.
I’ve reviewed several conference calls this morning – all reporting cost pressures and intentions to pass on price increases. I thought the Packaging Corporation of America (PKG) and Kennametal (KMT) calls were particularly interesting and to the point. For those who believe the increase in inflation is just a “one-month wonder”, it may be worthwhile to perform an assumption check by viewing the economy through the lens of a business operator. A good place to start, in my opinion, is with this quarter’s earnings reports and conference calls.
Packaging Corporation (PKG):
Q: Just following up on George’s question on the cost inflation you are seeing in 1Q, the reference is to higher labor and benefit costs. Is that just the normal annual wage increases that you would expect? Or are you seeing any kind of incremental wage pressure with a tighter labor market that you might not have normally expected?
A: It’s the normal inflationary effect that you see every year with our wage increases benefits and fringes but also, we are in a tight labor market. And as you would expect, we are going to manage that tight labor market. We have for the first time that I can recall, we have a robust economy that presents an opportunity for us to grow significantly with the customer base. In order to do that, again, you have a labor factor that we haven’t seen in this country for probably 20 years.
Q: …I’m curious specifically on how you’re doing on the price side because I know you had some increases a few months back and I think you mentioned that you’re planning more and maybe just flush that out a little bit?
A: Now in any given quarter, there might be a slight lag, but certainly over the mid-term we think that on average we’ll be able to offset the cost increases for material with the price increases.
And then, of course no customers are really excited about getting a price increase, but I think many of them expect it because there’s increased level of activity.
Many customers have not had a price increase for four or five years and yet they have continued to enjoy the productivity benefits from the new products that we’ve brought online and enhancements to the existing products.
While I don’t know the exact rate of inflation, I’m growing confident in a few things. First, wage pressure and price increases are relatively new economic variables for many businesses this cycle (I began noticing in 2017). Kennametal’s comment “customers have not had a price increase for four or five years” illustrates this well.
Second, the job market is very tight for skilled and entry-level labor. Packaging Corp’s comments on the labor market are similar to those of many companies in need of skilled employees.
Third, I’m not expecting the trend in inflation to reverse in the near future, as I believe cost and wage pressures remain in the pipeline (inflation lag is noticeable).
And finally, inflation etiquette and psychology is changing. As Kennametal’s comments imply, asking for a price increase is no longer taboo, but in some cases expected.
In my opinion, barring an economic shock or sharp decline in asset prices, the new trend in costs, wages, and prices is not going away after one jobs or inflation report.
If inflation continues to come in higher than expected, how will policy makers respond? Will three or four rate hikes in 2018 be sufficient? We’ll find out, but for now the Fed’s gradual and transparent approach does not appear very effective in altering the behavior of business or the financial markets.
Assuming current trends persist, I expect the Federal Reserve will eventually be faced with the difficult decision of either fighting inflation or protecting asset prices. Based on Chairman Powell’s recent comments regarding “financial stability”, along with the slow and measured pace of the current tightening cycle, it appears their decision may have already been made.
Have a great weekend!
Transcript source: Seeking Alpha