In November’s post “Few Friends for New Trends” I wrote, “Will incoming wage data and shifting trends in inflation eventually force bond and equity investors to reconsider their valuation assumptions and long-held beliefs? Current bottom-up analysis suggests it’s possible, but only time will tell if new trends in cost and price will persist or be acknowledged.”
Throughout most of 2017, my bottom-up macro opinion differed from the consensus. Specifically, through the eyes of the businesses on my possible buy list, I was noticing rising corporate costs and wages. Meanwhile, many investors – often guided by government economic data – believed wage and cost pressures remained subdued.
The consensus view on wages and inflation abruptly changed on February 2, 2018 when the Bureau of Labor Statistics (BLS) reported average hourly earnings increased 2.9%. While I do not use government data to form my macroeconomic opinions, most investors and economists do. As such, considerable attention was given to the “higher than expected” increase in wage growth. The yield on the 10yr Treasury increased to 2.85% while the Dow fell over 600 points. Suddenly, the popular view of interest rates and inflation remaining lower for longer was being challenged.
As the financial markets remained unsettled last week, it appears investor concern regarding rising interest rates and inflation may be stickier than most “buying opportunity” pundits suggest. The media is also paying closer attention to inflation. In the article, “Bond-Stock Clash Has Just Begun as Inflation Looms” Bloomberg writes, “The tug-of-war between stocks and bonds is at the heart of the shakeout rolling financial markets. This week’s U.S. inflation report could hold the key to the next phase.”
While I agree with Bloomberg’s comments regarding the tug of war between stocks and bonds, I disagree with this week’s inflation report being “the key to the next phase”. In addition to the numerous adjustments made to the Consumer Price Index (CPI) that reduce its objectivity, I don’t consider consumer prices as a reliable indicator of future inflation trends.
After reviewing Q4 2017 operating results, it appears the upward trend in corporate costs and wages remains intact. However, this is a generalization. Rising costs are not spread evenly between business and industry – some are experiencing more (transportation and construction) while others less (absolute return value managers 🙂 ). Furthermore, rising costs are typically absorbed or passed on unevenly and at different intervals. For instance, many cost increases are not passed on to the consumers immediately – there is often a lag.
The inflation lag can be seen in certain quarterly operating results and conference calls. For example, The Kroger Co. (KR) discussed the inflation lag in their most recent call stating, “Our inflation at cost is still above our inflation at retail…but they are beginning to converge and both of them are now in positive territory. They were both over zero, so we did have cost inflation as well as retail price inflation that got passed on, but we didn’t pass all of it on.”
In addition to the lag between cost and price, the degree of price increases or adjustments varies. Based on my observations, industrial and transportation companies appear to be passing on rising costs more easily and completely than most. Conversely, while some consumer companies are also experiencing higher costs, they are proceeding with price increases more cautiously. Consumer sectors with overcapacity, such as certain areas of retailers, remain. However, this trend could change as inventories decline and more consumer companies fail and consolidate (Sports Authority bankruptcy is a good example– initially it hurt the industry due to aggressive inventory mark-downs, but ultimately it helped the surviving competitors).
The ability to pass on price increases also depends on the goods or services being offered. For example, the price of a new home is increasing much faster than a tube of toothpaste. In my opinion, this phenomenon is partially due to the influence of credit. In addition to stimulating demand, easy credit and low interest rates can increase the ability of consumers to purchase large ticket items, even as prices are inflating.
For example, if the average price of a new home increases 8% (as LEN and KBH reported), a consumer amortizing the increase over 30 years may not flinch, especially if an “innovative” adjustable rate mortgage is used. We’ve seen this in the auto industry as well, with the rising price of an average vehicle increasing while monthly payments remain unchanged (thanks to longer term loans). Education is another good example. With ample credit availability, students are able to finance the rising cost of tuition over many years. Aggressive vendor financing and stock buybacks (asset inflation) funded with debt also make stomaching rising prices easier. To summarize, if financing with easy credit is an option, there is a greater chance price increases will stick and even accelerate.
In conclusion, although I continue to notice signs of rising corporate costs and wages, it’s difficult to determine if this week’s CPI report will be impacted and to what degree. Due to the inflation lag, I do not believe the CPI report is a particularly useful guide in determining current inflationary trends. Instead, I believe information on producer costs and wages may provide investors with a more accurate and timely measurement. In other words, at this stage of the cycle, inflation in the pipeline may be a more important variable to consider than inflation that has been passed through to date.
It remains a very interesting part of the market cycle. Investor psychology and perceptions are changing. The trends in cost and wages that began to appear last year are only beginning to be acknowledged by investors. Barring a sharp decline in asset prices, I expect rising corporate cost trends to persist. As such, I continue to believe the cozy relationship between interest rates and equities is over. In other words, the portion of the market cycle that rewards all asset classes simultaneously appears to be coming to an end. In my opinion, one CPI report, positive or negative, will not change this.