Corner of Wall & Main: Yes, Virginia, That's Inflation

 | Jun 18, 2014 | 12:00 PM EDT  | Comments
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The week began with renewed concerns over Iraq and rising oil prices, not to mention the question of how the U.S. would handle Ghana at the 2014 World Cup. If look at the S&P 500's action over the last few days, we might get the idea that we are simply entering the summer doldrums -- and, yes, fairly soon market activity will undergo the usual seasonal slowing. But the reality is that the economy is still on a somewhat shaky path. Even though the manufacturing sector continues to hum, at the forefront this week is the inflation that we've talked about in past editions of Corner of Wall & Main.

First, the good news. On Tuesday, we learned that May industrial production rose 0.6%, and the April decline was revised to 0.3% from the original dip of 0.6%. Not to throw a wet blanket on this report, but it was pretty much in line with prior readings from the Institute for Supply Management's manufacturing index and the purchasing managers index from Markit Economics.

Still, it's good to see confirmation -- and, once again, the data bode well for manufacturing and related companies such as Parker Hannifin (PH), Ingersoll Rand (IR), Eaton (ETN), General Electric (GE) and Honeywell (HON). It's also good for the transportation stocks, seeing as how these parts, components, sub-assemblies and finished products need to get from factory to storefront (or equivalent): Railroad names such as Norfolk Southern (NSC), Union Pacific (UNP) and CSX (CSX) should take benefit, particularly with gas prices on the rise.

Now, the so-so news -- housing. The first half of the week brought two pieces of housing data -- the June housing-market index from the National Association of Home Builders, which rose to 49 from May's 45, and housing starts for May.

The NAHB index was favorable, but single-family housing starts, were lower than those seen in both April and March -- and one month does not make a trend, but this still raises a red flag. It get back to the point that Chris made earlier in the year: We need to be selective when it comes to homebuilders. The Thematic Growth Portfolio, for its part, continues to own shares of Toll Brothers (TOL).

Lastly, the not-good news -- inflation picked up in May. Again, we've been watching the trends in several commodities, and we've all read the announced price increases from McDonald's (MCD), Sonic (SONC), Chipotle (CMG), Kraft Foods (KRFT), J.M. Smucker (SJM) and others. Against that backdrop, we were not surprised to see the May consumer price index come in hotter than expected, posting its largest increase in more than a year. Food prices, meanwhile, posted their biggest rise since August 2011.

We're also seeing the beginning of minimum-wage hikes in several cities, most notably in Seattle and potentially in San Francisco. In our view, these will only add to the margin pressures being felt by the above quick-service restaurants, as well as by Burger King (BKW), Dunkin' Brands (DNKN), Wendy's (WEN), Panera (PNRA) and others. So these are not the kinds of companies in which we'd be looking to invest.

Instead, we'd favor such names as McCormick (MKC), B&G Foods (BGS), General Mills (GIS) and Kellogg (K). These companies should benefit from what we expect will be a trade-down in what and where the average consumer eats. In addition, they all have healthy dividend yields, and their shares have all pulled back over the last few weeks, making for a far more palatable risk-to-reward proposition.

If you are unsure that we are seeing higher prices, we suggest you read up on the "Bacon Cheeseburger Inflation Index" from brokerage ConvergEx. (We find it best not to rely solely on government-issued data.) According to the index, the average bacon cheeseburger's cost has risen 7.9% year over year. Lest you think the Cheeseburger Index is full of it, the Bureau of Labor Statistics confirms that prices for bacon, ground beef and American cheese are respectively up 16.4%, 10.5% and 10% vs. last year.

We suspect more than a few people will be eating a few less bacon cheeseburgers when they fire up their grills this summer. If you notice people eating more hot dogs instead, you may want to pick up some a side of ConAgra Foods (CAG), given their ownership of Hebrew National brands.

Waiting on the FOMC. Later today, we'll be getting the Federal Open Market Committee's interest-rate decision, along with an update on its stimulus-tapering efforts. We suspect the commentary will continue to point to an improving recovery that is mixed, and we would not be surprised to hear the Federal Reserve lament on the velocity of job creation.

It will be interesting to see whether the Fed comments on inflation and, if so, what it has to say. Recently, St. Louis Fed President James Bullard commented that inflation is "moving higher." If the trend continues, Wall Street could move up its interest-rate hike expectations to the first half of 2015 from the back half of the year.

While the Federal Reserve has grown its balance sheet enormously (red line on the chart below), the velocity of money has simultaneously fallen to all-time historical lows (blue line). That has countered the potentially inflationary impact of quantitative easing. The danger lies in just how quickly this entire picture could change if the market's prevailing narrative moves toward the belief that inflation is a credible threat.

M2 Money Stock, Fed Balance Sheet -- 1966-2014
Source: St. Louis Federal Reserve

Material rates of inflation could arise if the previously dormant excess liquidity is deployed due to fears of rising prices. That, in turn, could spur an exodus from cash and increase the velocity of money -- thus making fears of inflation a self-fulfilling prophecy.

We are assured that Fed officials are well aware of this danger and that they have the tools and know-how to prevent such a crisis. But there isn't much to prevent us from fretting, given the institution's track record on awareness of impending crises and its accuracy concerning economic forecasts. This is a very real threat that cannot be ignored, particularly in light of the evolving data, even if it ultimately doesn't come to pass.

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