The Many Faces of Inflation
by Brian Pretti CFA, Contrary Investor. June 6, 2008
One of the key debates among investors at the moment is that of greater macro inflation versus deflationary forces. Go ahead and check out investment message boards/forums focusing on gold, commodities in general, housing, etc., and the debate is hot and furious. You'll see the same thing in the divergently opposing outlooks of many headline financial market commentators. For most, it's simply a black or white choice, with about zero potential for any gray to enter the picture. Personally, I believe in coexistence. Really going back to the beginning of this decade, my macro investment credo has been that both proactive sector and asset class selection, as well as equally important selective and proactive sector avoidance, is key to successful investment outcomes in the current environment. As we stand here today, there is absolutely no reason to alter this philosophical outlook. That means in both sector and broader asset class characterizations, we can indeed experience both inflation and deflationary nominal pricing pressures, dependent, of course, on the individual sector or asset class being analyzed. So, although I want to hopefully provide some perspective on headline inflationary trends and how those trends directly relate to our investment activities in the here and now, in no way will this be a debate over definitive macro inflationary or deflationary pricing outcomes. Why? Because of the expectation that both are to occur simultaneously, as we have been directly experiencing over the last few years.
Very quick definitional tangent. In academic terms, inflation is an expansion in the money supply and theoretically has little to do with "prices" per se. Asset or commodity specific price changes are a symptom of monetary expansion or contraction, as well as being driven by real world supply and demand forces. But you know the general public and so many on the Street don't equate monetary policy and nominal prices in the same sentence, so to speak. When talking about inflation in this discussion, it refers to popular perceptions of price. Why? Because that's how the consensus thinks of inflation. Regardless of academic definitions, we all need to put ourselves in the shoes of the consensus, of the broad population of investors that do indeed set financial asset prices each and every day. For the academic purists out there, just wanted to make that clear.
Having said all of this, let's cut right to the chase and get to the issue most important, and hopefully most helpful in our here and now investment activities as far as headline inflation is concerned. Point blank, periods of rising headline inflationary pressures have been associated with periods of contracting equity valuations. Important point being, if we are to look for a better tone to the equity market any time ahead, a key structural support to that better tone would be inflationary pressures that are declining on a rate of change basis. To be honest, history is very supportive of this idea. Below is a chart that tracks both the year over year rate of change in headline CPI set against the longer term S&P 500 P/E multiple. A quick tangent. Historical Robert Shiller P/E data is being used in the chart. Yes, we know the Shiller data can be controversial. No, it's not a forward P/E multiple history, so as you look at the chart, you see a current valuation level higher than what you'd see if you were looking at current price relative to forward S&P analyst earnings estimates of the moment. To be honest, using Shiller data or some other type of P/E multiple methodology for the sake of this exercise is virtually immaterial. Directional rhythm of so many P/E valuation series are similar. What's different is absolute levels at any point in time. But as you'll see as you look at the chart, what is important here conceptually is directional similarity and consistency in rhythm across time between headline CPI trends and corresponding S&P P/E multiples. One last point, this chart was created a few months back, so the CPI data is a few months stale. As of the April reading, the year over year rate of change is now 3.9%, not terribly far off what you see below. Have a look.
Yes, there sure are a lot of red bars in this chart, aren't there? The bars represent periods where the year over year rate of change in CPI was rising meaningfully from trough to peak. Only one rising CPI period is left out, and that was the environment leading up to the macro equity market peak in late 1999/early 2000. As you know full well, almost nothing was influencing equity valuations at that point, with the exception of maniacal momentum. Other than this period being a bit of an exception, as we simply visually inspect the chart, all other periods of rising year over year CPI were associated with a declining S&P P/E multiple. As far as the importance of inflationary measures of the moment are concerned, this is THE issue to be considered vis-à-vis the macro outlook for equities. Point blank, if inflationary pressures continue to rise ahead, that's going to be a boat anchor around equity valuation expansion possibilities. Meaning? Real world earnings then become wildly important to forward equity progress. Of course, that and the extent of Fed liquidity adventures ahead.
Very briefly in terms of explanation, this phenomenon is pretty much common sense. In rising inflationary periods, rising corporate revenues and earnings are more reflecting price inflation as opposed to organic revenue and earnings growth, all else being equal. Here's a relatively dramatic example for you, but it completely proves the point as to why equity investors should not "pay up" for corporate earnings that are driven in large part by general price inflation, and why macro equity valuations should indeed contract when the general level of inflation is rising. In inflation adjusted terms, S&P 500 earnings in early 1968 and again in 1982 were equivalent. Over this same period of time, reported S&P 500 nominal earnings were up 140%. Also over this same space of time, the S&P in price only terms was up less than 5% point to point. Over this period of clearly accelerating inflationary pressures, the equity market was indeed very efficient. It looked right through inflating corporate revenues and earnings by imposing almost perfect continuity of contracting P/E valuation multiples across the entire period. A dramatic longer cycle example? You bet it is. But, again, as we eyeball the chart above, this same valuation contraction phenomenon is seen again and again as headline CPI rose meaningfully on an annual rate of change basis.
Back to the future of the here and now. There is simply no question that in good part, nominal corporate earnings in aggregate are still expanding, especially when financial sector earnings are backed out of the equation. In fact, as you may have seen discussed as of late, if one were to back out financial sector earnings from aggregate S&P fourth quarter 2007 earnings, the year over year increase in reported earnings would have exceeded 13%. Hey, wait a minute, that's not bad at all. In fact quite the opposite. So why the less than satisfying equity market activity YTD? It's rising headline inflationary pressures of the moment that is acting to contract equity valuations, whether investors realize it or not. So theoretically if corporate earnings grow ten percent ahead, yet inflationary pressures act to contract equity valuations by ten percent, investors are essentially going nowhere really fast. I've belabored the concept enough here. Rising inflationary pressures simultaneously constrict equity valuations. This is the issue of the moment. As a final comment, this relationship is simply exacerbated in a slowing economic environment. A stagflationary environment is a boa constrictor for equity valuations. Academically, if investors are looking for a meaningful rise in equities any time soon, then they simultaneously need to be looking for a significant peak in the rate of change in year over year CPI with a subsequent decline to follow in very short order. Simple enough.
So, if indeed we need declining inflationary pressures to at least in part come to the rescue of equities in terms of possible valuation expansion, how likely is that to happen any time soon? Although I wish I could give you some type of definitive answer, you're going to have to settle for a little bit of perspective. As detailed in the past, I prefer to look at many trends on a six, nine and one year annualized rate of change basis. It's there where we get the sense for shorter-term trend acceleration or deceleration. So without further adieu, let's apply this little exercise to some reported inflationary trends of the moment. The following table does the trick.
|Period||Headline CPI||Core CPI||CPI Food||CPI Energy|
|6 Mo Annualized||4.5%||2.2%||5.7%||21.9%|
|9 Mo Annualized||3.9||2.2||5.2||15.6|
|12 Month Rate Of Change||3.9||2.3||5.1||15.5|
At least as of April, the near term acceleration in price trends is crystal clear literally across all measures shown in very consistent fashion, of course with the exception of the Fed favorite core rate which has been hypnotically stable.
In a macro sense, it's going to make it tough for equities to even have the potential to experience any type of valuation or multiple expansion any time soon without meaningful deceleration in the CPI components. So what that means is that on a short term basis, we really need to home in on inflation adjusted trends in both corporate revenue and earnings growth as we consider individual investment opportunities. For those companies that can achieve pricing gains above general inflationary trends, they may indeed be accorded premium valuations relative to their brethren. We've seen exactly this with energy, ag and materials issues. But as we step back and look across the breadth of wider historical experience, there is one other consistency in inflationary patterns of the past that we need to acknowledge and monitor closely as we move forward. Another large debate among many Street seers of the moment is whether the US has already entered a recession, despite the official numbers of the here and now. As you know, since official US recessions are only documented in hindsight, no one knows for sure at this point. In the recent 1Q GDP revision, the deflator (inflation measure) clocked in at 2.6% rate. Believable as being representative of the true US inflation rate of the moment? I'll leave that for you to decide. But the very important issue surrounding recessions is that in cycles past, annual rate of change in headline CPI has tended to peak either leading up to or during these recessionary interludes, or is already in rate of change decline prior to the end of the official recession itself.
The fact is that as per the message of history, equities have bottomed prior to the official conclusion of recessionary interludes. A very meaningful part of the reason why this has happened is because headline inflation was peaking on a rate of change basis at exactly the same time. Declining inflationary pressures mean equities have the opportunity to experience valuation expansion as they "look ahead." History is very clear in terms of the peaking of CPI on a rate of change basis in recessions past. Below is a graphic example that absolutely proves the point. The chart documents the year over year change in headline US CPI with official recessions past marked with the red bars.
Now that we are aware of this historical experience, should we as equity investors really be welcoming a US recession as providing the ultimate slowdown in inflationary pressures that could indeed drive macro equity market multiples higher? If indeed history is to repeat itself ahead, that's not too bad an assumption and expectation. THE wildcard in the current inflationary equation is globalization. In other words, how much can we attribute the inflationary pressures that we now see in nominal prices to growing physical demand in the foreign and emerging economies, the decline in the US dollar versus foreign currency cross rates, etc.? As you know, this question is most pertinent to the obvious food and energy price pressures we are experiencing. I suggest that we need to view inflationary factors in much broader terms than just the singular domestic CPI numbers. We all know that the US has indeed enjoyed importing deflation in many senses for quite some time, with particular emphasis on consumer products coming from Asia. But inflationary pressures of the moment, particularly upward energy and food price pressures, are indeed influencing the global economy and global nominal dollar pricing. And this influence has now clearly turned the tide in terms of US import price trends. The following chart is elegant and telling in its simplicity.
As of the first quarter of 2008, the year over year rate of change in US import prices rests at a level not seen since 1981. The change in important prices exclusive of petroleum costs has achieved a level last seen in 1989. Are these the inflation trends we should be watching and will they have a bearing on US equity valuations? Maybe the best I can suggest is that we need to be open to the idea that current trends in globalization may indeed change the nature of past patterns in domestic inflationary pressures influencing US equity valuation multiples. We need to broaden our view to the global. Although this is no massively new or wild revelation, we academically backed into a huge question of the moment. Yes or no, will domestic inflationary pressures subside on a rate of change basis as the US economy slows? Or will the influence of globalization override this, even to a point, in the current cycle? Given the flow of thinking so far in this discussion, the correct answer to this question has very meaningful bearing on forward US equity market performance. Without stretching for sensationalism, I believe this is probably one of the most important sets of issues for the financial markets over the next twelve to eighteen months.
Face The Music And Dance?
Certainly one of the key questions of the moment is whether what is happening with clearly meaningful upside pressure in global food and energy price inflation will ultimately flow into core inflation trends, and if so by what magnitude. The chart below is very simple. It's the year over year rate of change in headline CPI subtracted from the year over year change in core CPI. What are we essentially looking at? Food and energy price inflation in isolation. You know, the stuff that the Fed and friends tell us not to look at. About as simple as the day is long. As is clear, there have been some very meaningful upward and downward spikes in this relationship over time. Anomalistic, spikes upward or downward in this simple ratio were meaningful tip-offs, or leading indicators, of very important financial market and economic change to come. Secular change. Admittedly, this graph was created with the clarity and 100% certainty of hindsight. Was it that the very large spike in energy and food price inflation in the early 1970's, again in hindsight and due to the energy crisis of that period, was the signal that broader inflationary pressures AND higher interest rates were about to befall the US economy and financial markets? Likewise, was the early 1980's spike downward the clue that change in broader trends was to occur as macro disinflationary forces were about to take command? Again, in hindsight it gets pretty easy to make these types of observations. But certainly the reason I bring this up is that the upward spike in this very ratio has again occurred in recent years, as well as over the last six months. Is this the conclusion, or final bookend, to the disinflationary macro trend begun just over a quarter century ago? This is exactly the kind of historical relationship that reinforces my caution on the potential for equity market valuation multiple expansion at the moment, and really has me thinking more about the potential for valuation compression than not.
Lastly, as we listen to Street pundits far and wide pontificate about inflationary trends ahead (again, remember as per the consensus thinking regarding inflation that is nominal dollar prices), we hear again and again that inflation is not about to become a real problem in the absence of wage inflation. And as we all know, current wage inflation is occurring at a rate even below that of the headline CPI numbers. History does indeed tell us that, as an example, significant inflationary pressures seen in periods such as the 1970's were indeed accompanied by meaningful wage inflation, ultimately reinforcing the primary trend in higher nominal prices system wide. But these pundits tell us that since there is no real nominal domestic wage inflation at the moment, the risk of higher macro inflationary pressures continuing is small. Or as the Fed and friends would tell us, "inflation is contained." This is narrow thinking. You're darn right, wage pressures domestically are indeed subdued. And this is exactly why US consumers are being squeezed at the gas pump and at the grocery store. But again, we need to think broader terms. It's globalization, globalization and globalization...and little else in terms of analytical framework. Although wages are not growing domestically, what about the global wage frontier? Decade to date in the US, payroll employment is up 5.7%. It's the lowest decade to date US percentage payroll employment growth number on record over the last half century at least. Global corporations are drawing on a global employment base. Although wages are not growing domestically at a rate exceeding even the heavily massaged CPI, that's not the case at all in foreign markets.
Let's try to put this into perspective with one last chart. I've taken the chart above and this time overlaid the year over year rate of change in US service sector hourly wage growth. We're looking at service sector wages, as the US service sector is clearly the dominant domestic US employer of the moment. As you can see, energy and food price inflation combined are running a good 2% ahead of the core CPI numbers right now. We saw exactly this same set of circumstances in the late 1970's. But in the late 1970's, the year over year rate of change in hourly service sector wages was accelerating from 5% to 9%. Today? Less than a 4% growth rate in domestic wages.
Question being, will global energy and food price pressures soon abate simply because US wages are growing at a rate well below historical experience in prior macro inflationary interludes such as the 1970's? Or in a globalized world, will the US singularly be much less of a factor in terms of driving global commodity prices, regardless of US wage trends?
Although the total story remains to play out ahead, we need to view inflationary price pressures within the context of the global environment. We also need to be open to the idea and incorporate into our thinking that it is different this time in that inflationary trends that are set in the global marketplace will influence the rhythm of domestic US equity valuation multiples. So after all of this explanation and analysis, what is the point? Inflationary headwinds are global in nature. The US economy domestically is less a price setter or price determinant than has been the case anywhere in recent history. Academically, equity valuations are inversely correlated with inflationary pressures. We need to keep this in our thoughts and incorporate it into our behavior and decision-making as investors. It is absolutely clear that in the context of the global, commodities are being repriced upward, driven by demand, currency cross rates and institutional investment in commodities as an asset class. For now, the wage growth following these pricing pressures is most meaningfully being experienced in the emerging economies, while the industrial economies face increasing social contract (social security, Medicare, etc.) costs ahead. Social costs, which have not been funded, are at great risk of being monetarily inflated away. Finally, as seen above, domestic wage pressures are currently subdued relative to historical experience seen in rising macro inflationary environments of the past. Will this ultimately pressure corporate earnings ahead as consumer spending is pressured? Earnings that will become a key focal point if indeed inflationary pressures weigh down upon equity valuation multiples? As the global economy and financial marketplace continues to evolve, our thinking, analysis and approach to valuation must also evolve. If inflationary nominal dollar price trends of the moment do not abate, equities in the macro face the headwinds of valuation multiple compression. And that means actual corporate earnings will have to work that much harder in terms of propelling equity prices higher. And that tells us sector specificity in terms of active participation and active avoidance will continue to be critical to investment outcomes.
© 2008 Brian Pretti