Inflation is like toothpaste
“Inflation is like toothpaste. Once it’s out, you can hardly get it back in again. So the best thing is not to squeeze too hard on the tube.”
That quote, famously from Karl Otto Pöhl, sums up the dilemma facing investors this year. Karl Otto Pöhl was a German economist and president of the Bundesbank from 1980 to 1991. He died aged 85 in 2014. As a central banker he struggled to control what was by contemporary German standards runaway inflation of about six per cent.
Figure 1. CPI for All Urban Consumers: All Items Less Food and Energy in U.S. City Average
As of 10 February 2022. Source: U.S. Bureau of Labor Statistics.
In relation to the current market situation, core CPI came in yesterday above consensus showing that US consumer prices climbed 7.5 per cent in the year to January. Equity markets fell following the data, prompting speculation of the Federal Reserve rapidly raising borrowing costs. There was even chatter about an emergency rate hike over the weekend after St. Louis Fed President Bullard’s comments stating his desire to "see 100 basis points" of hikes by July and commenting the possibility of the Fed being open to an inter-meeting rate increase. On back of all of this sent the yield on the benchmark 10-year Treasury note above 2 per cent for the first time since 2019.
Similarly, to Karl Otto Pöhl’s time as a central banker, credibility to fight inflation is at stake. The continued upward surprises in inflation and tightness of the labor markets have spooked central banks. For many market participants that credibility appears be fading as the politics of inflation is becoming increasingly challenging for governments. Some have a view that the dreaded wage inflation spirals not seen for 30 years might come back. Bank of England Governor Bailey even suggested that workers should not ask for too large a pay rise.
To complicate things further for central bankers, in recent weeks, energy commodity prices have been spiking. Unless energy prices stabilize in coming months, inflation will have a hard time moderating. The challenges are exacerbated by low inventories and low spare capacity, amid low levels of capital expenditure.
While some of the inflationary factors are driven by surging transportation costs or supply bottlenecks, but it is unclear how long they will prevail and to what extent they finally will pass-through to consumer prices.
In terms of the consumer good companies, there is continued bifurcation between companies with and without pricing power. We expect margin pressure to be the predominant theme through the rest of this earnings season. For many companies, like Clorox, as shown in the picture below, the inflationary pressures have been much greater than the market had anticipated. Their gross margins decreased by 1240 basis points.
Historically, however, the sector has had strong pricing power and has been able to pass increased costs on to consumers without sacrificing volume growth. This has the potential to lead to more sustained price pressures.