This note was originally published at 8am on February 16, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“Epidemics are sensitive to the conditions and circumstances of the times and places in which they occur.”
Epidemic might be the right word to describe the environment in the USA that has ensued since Bernanke’s speech in Jackson Hole and the 96.3% move in the S&P 500 since March 2009. There are many corners of the world that are looking at the USA and the policies of the Federal Reserve and clearly believe that we are pouring gasoline on a blazing hot fire.
The past month’s protests in North Africa and the Middle East were partly linked to surging agriculture costs and according to the UN, countries in Latin America are most at risk of food riots as prices continue to head higher. According to the World Bank, rising global food prices have pushed 44 million more people into “extreme” poverty in developing countries since June. Yet the USA and the S&P 500 continue to power forward like they are impervious to these issues.
Not so fast…. The question is when, not if, Chariman Bernanke will pull the punch bowl on the current liquidity binge. The increased civil unrest that ensues around the world will continue to put incremental pressure on him to alter the current policy. The scary part is he needs to do it sooner rather than later and chances are it’s going to happen at exactly the wrong time.
Just by chance, what if we get a hint of a FED exit strategy today at 2 pm just as the “storytelling” is reaching a feverish pitch? I’m hearing people talk about stocks, saying, “This time it’s different!” Or how about this one, “margins don’t matter!” Or better yet, “consumer companies are impervious to rising input costs!” Over the next 12-months we are going to be able to produce some serious You-Tube moments that will last a lifetime.
Of course margins don’t matter – until they do. Consumer companies are impervious to rising input costs – until they are not. And we are at the tipping point!
It seems like yesterday that Malcolm Gladwell published The Tipping Point: How Little Things Can Make a Big Difference. Gladwell describes a tipping point as “the moment of critical mass, the threshold and the boiling point.” In nearly every situation there is that moment in time when the world is ready to follow the leader or “the trend.” Right now, that leader is Chairman of the Federal Reserve, Ben Bernanke and the trend is excess liquidity that is leading to higher inflation and higher stock prices.
The critical element of the U.S. economy that is not benefitting from the Federal Reserve’s actions, in real terms, is the consumer. I believe that the consumer is reaching a tipping point. Accelerating demand is critical to maintaining profitability in an accelerating cost environment. What we saw yesterday from the retail sales data was perhaps an indication that the consumer is beginning to slow down.
In the face of non-confirming data, observers with a conflicted or biased view often look for any other metric, or any other narrative, to justify a prior perspective. Revisionist versions of the truth are offered with adroit semantic maneuvering and frantic searching for the comfort of a confirming thesis.
One narrative being promoted at the moment is that consumers are willing to pay above market for “green” products from “socially responsible” companies. This may be true to a degree, but deflecting the clear truth behind the data, be it Retail Sales or otherwise, with qualitative narratives that are entirely subjective, is not a practice I subscribe to. If consumers see raising prices in the absence of a corresponding growth in personal disposable income, there is likely going to be a change in consumer behavior.
As Gladwell wrote, "Ideas and products and messages and behaviors spread like viruses do.” At present, it is clear that many ideas and messages have spread rapidly around investor circles. Sectors of the market are trading at premium multiples largely because of the free-money policy of the Federal Reserve. The confidence that this instills in investors seems to trump any concern about companies’ ability to control their input costs from now on.
For many companies, the cost of raw materials is rising at a faster pace than revenue and we have only just begun to see the impact on margins. Rising costs take time to flow through to the bottom line. Rhetoric from management teams, against all of their incentives, has been decidedly cautious with respect to their commodity cost outlook. As we move through the balance of 2011, the squeeze on profit margins will be more pronounced than most analysts expect.
The Empire Index' Prices Paid index, which climbed to a two-and-a-half-year high of 45.8, was supportive of my theory yesterday. Quoting directly from the press release, "The prices paid index climbed to a two and-a-half-year high in February, but the measure for prices received was little changed, suggesting some pressure on profit margins." That’s right – margins are contracting, not expanding.
How the consumer reacts to increased inflation pressures will be the tipping point for the market. Across a wide spectrum of the S&P 500, companies are seeing margins contract, and some are more confident than others in their ability to pass on price to customers. A growing percentage of companies will be unable to increase price at all, or fast enough to offset margin contraction, without hurting top line trends. The economic recovery is in its embryonic stages, unemployment remains high, and consumers are keeping a tight rein on spending. How much inflation can they take before spending begins to suffer?
I heard some supposed experts on CNBC say that $5.00 gas will not affect consumer spending. It’s this kind of storytelling that is sign of pure excess.
Perhaps yesterday’s Retail Sales was the first glimpse of this trend. Retail Sales growth missed Street expectations. The trajectory of 4Q10 sales trends cannot continue with inflation accelerating and job growth proving to be highly inadequate as an offset.
Over the next two days we will be getting more inflation readings from the PPI and CPI. While these two numbers are conflicted calculations, they will both point to accelerating inflation. For proof of this trend, last night in an interview on Bloomberg, Richmond Fed President Lacker (non-voting FOMC member in 2011) said that US inflation may accelerate in H2 of 2011 as firms seek to recoup higher commodities and health care costs.
And Joe six pack is going to roll over and say thank you very much!
Function in Disaster; finish in style