More About Inflation

As we discussed previously, inflation uncertainty is one of the key factors driving the recent increase in market volatility. With the significant fiscal boost to the economy in the form of individual and corporate tax cuts as well as the additional leverage from increased government borrowing, the markets are worried whether this economic boost could spark inflation. Inflation could be neutral or bad for the markets depending on the ability of firms to pass on price pressures within their supply chains. Recent evidence has provided both positive and negative indicators about increasing inflation.

The negative indicator about inflation is coming from evidence that inflation is beginning to show up via increasing prices that companies are paying for raw inputs but that companies are not able to pass these price increases to customers. In a recent (March 18th) earnings call by General Mills, for example, the CEO said, “…we now expect our full year fiscal '18 total segment operating profit will be 5% to 6% below year ago levels in constant currency. The key driver of this change is a significant increase in supply chain costs…their input costs are rising faster than we had anticipated, in fact, we now estimate our full year fiscal '18 input cost inflation will be 4%, 1 point higher than our previous estimate.” The fact that GM is forecasting lower operating profit for the rest of this year as a result of these cost increases indicate that they do not anticipate being able to pass on this cost inflation to customers. This is good news for the fixed income markets - if firms can’t pass on cost inflation to customers, the macro-economy may not experience much inflation, thereby not resulting in big losses in the bond markets. However, if firms can’t pass on their increasing costs to customers, it will mean lower profits for companies, which in turn will mean big losses in equity markets. The recent losses in the consumer staples sector (of which General Mills is a key component) was driven by precisely this worry, and the worry spread to many other sectors in the equity markets. Meanwhile, the bond markets rallied in late March on this news.   

Other factors will also contribute to determine whether inflation affects the economy as a whole. Labor market expansion (workers who have been out of work for an extended period of time and now coming back into the labor force) due to the stimulus provided by the tax bill and lower regulations has so far put a cap on wage inflation. Trade tensions, however, will cause input cost inflation for companies in certain sectors due to the newly enacted tariffs on some raw materials.  

The main reason that we have been seeing substantially higher volatility in both the bond and equity markets for the last two months is that the markets are trying to understand which of these factors will dominate and if these factors might interact with each other in some way to result in the worst case scenario that we last saw in the late ‘70s and early ‘80s: stagflation, where both bond and equity markets drop.

Each week that passes brings new evidence that inflation is slowly making its way back into the economy. Inflation can only be hedged in a limited manner. The hope by most investors in the markets is that the Federal Reserve is able to move quickly enough to keep inflation in check.