Thursday, August 19, 2010

Inflation In The Pipeline

Of appropriate concern is the fact the economy could be entering into a period of deflation. The concern stems from the fact the Consumer Price Index continues to trend lower. As the below chart notes, the overall YOY change in the CPI is a little over 1% while the core CPI is near .9% (not shown.)

From The Blog of HORAN Capital Advisors

The inflation concern comes into play as its cause tends to be the result of a fall in overall demand. With high unemployment and thus lower anticipated consumer spending, the lower demand trend feeds into the bear case for the economy and the market.

A deflationary period would certainly have an impact on appropriate investment strategies for investors. In mild deflationary periods though, stocks tend to deliver fairly decent returns. More detail on stock returns in various inflation scenarios can be found in an earlier post I wrote titled, Where to Invest in an Inflationary Environment. The below chart details the average return for the S&P 500 during various inflation/deflation periods. The number in parenthesis represents the number of return periods for each range of inflation/deflation.

From The Blog of HORAN Capital Advisors
From a valuation perspective, looking at the price earnings ratio or PE, stocks will tend to trade at lower PE multiples in a deflationary environment; however, many of the high quality large company stocks are already trading at low PE multiples today.

At the end of the day then the relevant question is whether we are entering an inflationary or deflationary cycle. As the below table shows, inflation does appear to be entering the supply chain at the producer level. Argus Research notes:
"...Producer Price Inflation for finished goods has increased at a 4.2% rate over the past year through July. This is higher than consumer inflation, and up month-to-month from 2.8%. Deeper in the production pipeline, pricing pressures are even more pronounced. For intermediate and crude goods, prices have jumped 6.4% and 20.5%, respectively, over the past year...."
From The Blog of HORAN Capital Advisors

Deflation concerns certainly warrant watching; however, in mild deflation periods, there are investment categories that can generate profits for investors. From a PPI perspective though, inflation pressures appear to be bubbling up in the producer level of the economy. This higher producer price pressure often leads to higher consumer prices; hence, a potential counter to the deflation case.

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