Diverging Inflation Narratives

I was watching Bloomberg TV yesterday and a portfolio manager was asked about his current market outlook. He started by saying earnings growth is strong and inflation is subdued – a ripe environment for higher stock prices. This morning I read the following quote from James Bullard of the St. Louis Federal Reserve, “I just don’t see much inflation pressure”. Meanwhile, hundreds of companies in multiple industries are openly discussing the current inflationary environment, price increases, and a tight labor market. It’s as if Wall Street, the Federal Reserve, and corporate America live in different worlds.

It’s been approximately a year since I began noticing and writing about shifting inflationary trends (from a disinflationary environment in 2015-2016 to an inflationary environment in 2017-2018). While inflation has received more attention over the past few months, many investors and policy makers continue to assume inflation remains low and its recent uptick is temporary. With the dollar rising and certain commodities in decline, I’m open-minded and alert to another reversal in inflation (similar to late 2014); however, to date I am not seeing it. In fact, Q2 2018 operating results and outlooks support my belief that inflationary pressures are not subsiding, but are persisting and even spreading.

Rising average prices (see recent retailer earnings reports) are allowing many companies to pass on higher costs and grow revenues. Investment bankers beware. Companies may discover growing revenues through price increases is easier than taking on debt and acquiring. Price increases carry lower risk and are not capital intensive – better for margins and the balance sheet!

As price increases become more prevalent and acceptable, companies are becoming more comfortable asking for seconds and even thirds. As stated in past posts, inflation psychology is changing. In effect, it’s no longer poor business etiquette to ask for a price increase – it’s rational and understood.

Tariffs are also contributing to inflation and revenue growth. In fact, I’m beginning to wonder if tariffs are a clever way to grow sales and nominal GDP (and real GDP if inflation is underreported). Many management teams recently communicated their intentions to raise prices further assuming additional tariffs are implemented. For business, tariffs are just one more item they can point to justify raising prices.

Based on my bottom-up analysis, I believe the disparity between Wall Street and corporate America’s inflation narrative is growing. Furthermore, unless asset prices decline and the economy slows, I do not expect inflationary trends to reverse in Q3 2018. Company commentary and outlooks suggest the inflationary pipeline remains healthy and full. As such, I expect the Federal Reserve will continue to raise rates and proceed with its quantitative tightening (again, barring a sharp decline in asset prices – then all bets are off). As I wrote in Patience a Possible Win-Win approximately one year ago, I believe patient investors will either be rewarded with lower asset prices or higher interest rates. This continues to be the case, in my opinion.

Regardless of your views on inflation, I thought readers may be interested in learning how my macro views on corporate costs and pricing are developed. Instead of relying on government economic data, I prefer viewing the economy from the bottom-up, or through the eyes of business. Today I intended to list many of the inflation examples I noticed in my latest quarterly review, but the list was too long (near 100 examples and over 40 pages). If you’d like to learn more (especially if you “just don’t see much inflation pressure”), please shoot me an email and I’ll send some interesting and possibly enlightening weekend reading.

Thanks to a reader for picture/example of inflation psychology shift!