Tuesday, February 15, 2011

The "I" Word

In nearly every investment presentation I go to these days, the theme of most speakers invariably go toward one of the i-words (inflation; internet; internet; interest rates).

However, the most favorite topic these days is inflation.

A recent Merrill Lynch survey of mutual fund managers found that roughly 75% of those surveyed expect a significant increase in inflation. Even the most recent publication from bond guru Bill Gross discusses inflation.

Commodity prices are usually listed as the primary culprit for inflationary pressures, followed by government spending and Federal Reserve policy.

So I read with interest a story on the front page of the New York Times which detailed the apparent trend of companies that are raising prices to try to maintain their margins in the face of rising raw material prices.

But then I ran across these paragraphs:

The sharp rise in commodity prices since last year has not translated into all new records. Food commodity prices are about 8 percent below the high in the summer of 2008, while energy prices are less than half their zenith. Prices of a basket of other commodities are about 4 percent below the heights of mid-2008.

The cost of raw materials accounts for a small portion of the cost of most consumer goods, as labor, processing and packaging tend to make up a larger share of the price at the cash register. Foods like coffee, meat and milk, which are closer to raw materials, will probably show some of the biggest price jumps.

Companies that try to pass on all their costs could meet resistance. Although consumer spending has risen, unemployment remains at 9 percent, and average hourly earnings are up less than 2 percent over the last year.

In other words, commodity prices are higher, but most are lower than 2 years ago.

Moreover, as a percentage of the typical household budget, the rising prices that get the attention of most of us - food, gas, etc. - are not nearly as important to our overall financial picture as, say, the amount of money we spend on housing.

Finally, I would add one more point: Corporate margins are currently at all-time highs. Through a combination of other i-words - international outsourcing and judicious use of the internet - corporate America is reaping large profit rewards even when it is struggling to keep its top-line growing.

My suspicion is that for companies that face significant competition - for example, packaged food companies - margins this year are going to be squeezed, as consumers will be reluctant to swallow (pardon the pun) large price increases.