According to the Consumer Price Index (CPI), inflation is running at an 8.3% annualized rate, the highest level in four decades. Americans are worried. Over the last few weeks, Google searches for the “I” word have reached their highest levels ever, according to Google Trends.
On nightly newscasts and online, pundits opine on the subject. The consensus is that inflation is out of control and shows no signs of abating. Some “experts” even predict a return to the dark days of the late 70s and early 80s, when inflation peaked at ~15%, and the Federal Reserve was forced to raise interest rates to stratospheric levels, and by doing so, ushered the economy into a tailspin.
This week, investor William Ackman tweeted, “Inflation is out of control. Inflation expectations are getting out of control.”
At TQC, we respectfully disagree with him, and the consensus that inflation has run amok. In this post, we will argue that inflation has already peaked, is currently receding, and why it will continue to do so over the foreseeable future.
Shortages & Gluts
We believe inflation is transitory and will revert to its longer-term trend. Here is an important reason why.
Pandemics create shortages, which drive prices up, and gluts, which drive prices down. At the onset of the coronavirus pandemic, consumer behavior turned on a dime. People bought more (consumer goods) and did less (traveling, commuting, etc.).
Acute changes in buying habits exacerbated snarled supply chains resulting in retailers caught short of the items that people were suddenly demanding en-masse. In response, shops began voraciously competing for a limited number of those units to restock their shelves.
If a retailer knows they may not be allotted the number of units they desire, they will typically over-order. For example, if retailer X wants 100 units of Y but because of supply constraints only expects to receive 20 units of Y, they will order 500 units of Y, hoping to get ~20% of their order, or 100 units.
Microcosms & Macrocosms
A microcosm of this phenomenon occurred during the initial covid wave. Almost overnight, there was a surge in demand for hand sanitizer (and toilet paper)! Producers could not ramp production fast enough to satisfy demand. The moment a shipment arrived at a CVS or Rite-Aid, it was picked through in minutes leaving shelves barren. Hand sanitizers were hoarded and hawked on eBay for well above their suggested retail price. Retailers responded by over-ordering.
After the initial covid wave receded coupled with vaccines and anti-viral medications, demand for hand sanitizers collapsed. Simultaneously, all those (over)-orders were filled, and a glut of sanitizer hit the shelves all at once.
Retailers had so much hand sanitizer they ran out of space to store it. Some stores marked it down to ridiculously low prices, others gave it away for free or dumped it on the street because the cost of holding so much inventory would have exceeded the loss incurred by throwing it away.
A macrocosm of this phenomenon is playing out now.
When consumer buying habits shifted during the pandemic and shoppers displayed a voracious appetite for consumer goods, retailers responded by (over)-ordering inventory to satisfy increased demand and compensate for snarled supply chains.
Those orders are now reaching big box retailers.
Concurrently, the covid pandemic is morphing into an endemic, supply chains are improving, and consumer demand is normalizing. As a result, retailers are in the difficult position of getting slammed with inventory while demand is reverting pack to pre-pandemic norms. The numbers are not pretty.
Here is a sampling of annual inventory growth from major US retailers' latest earnings reports: Walmart +32%, Target +43%, Home Depot +32%, Abercrombie & Fitch +45%, Kohl's +40%, Dick's +40%, Lowe's +10%. Market pundits are worried. Excess inventories often portend a recession. However, in our view there is a silver lining.
Remember, pandemics create shortages, which drive prices up, and gluts, which drive prices down. The same retailers caught short of the inventory consumers wanted when the pandemic began, are now inundated with inventory as demand cools. To reduce their inventory to acceptable levels, they will – and in many cases already have – mark down prices. This is disinflationary and will be a primary driver of disinflation over the remainder of the year and beyond.
To be certain, not all industries are yet flush with product. For example, car dealerships are still woefully short of new vehicles on their lots. The primary reason is a shortage of semiconductors that are required to operate these computers on wheels. As a result, it is challenging to find an attractively priced new vehicle.
Our inkling is that in relatively short order semiconductor manufacturing will increase, and the likes of GM and Ford will suddenly be overflowing in the chips they have (over)-ordered.
In fact, this past week the CEO of Volkswagen, Herbert Diess said he is seeing "clear improvement" in semiconductor supplies and expects the automaker's global production can recover during the rest of this year. If Mr. Deiss is correct, new cars and lower prices are coming to a dealership near you.
Financial instruments exist that represent investors’ expectations of the rate of inflation for various durations in the future. The granularity of how these figures is compiled go well beyond the scope of this post. What is important is this: as of the close of trading Friday, investors “expect” inflation 12 months from now to be 4.69%.
To put that number into context, in mid-March, those expectations were 6.40%. On a two-year timeframe, investors expect inflation to be 3.91%, down from almost 5% in mid-March. These are very pronounced declines.
To help assuage people that further into the future inflation will not rear its ugly head, consider that 5-year inflation expectations are only 2.99%! down from close to 4% in mid-March.
One might notice an interesting phenomenon playing out along the inflation expectations curve. The prospects for inflation in the future are lower than for today. In finance parlance, this is referred to as an “inverted curve.” It is a powerfully predictive indicator.
Another inflation gauge is more simplistic, it is the U.S. Treasury bond market. Despite all the talk of inflation spiraling out of control, consider this: the yield on a 10-year U.S Treasury bond is only 2.74%. To be fair, that is up from 1.50% at the beginning of the year, (but down from 3.20% earlier this month).
Nonetheless, if investors truly believed what many pundits say – that we are returning to a prolonged bout of double-digit inflation – the yield on long duration U.S. bonds would be substantially higher than 2.74%, 3.2% or even 5%.
If inflation is indeed receding, why hasn’t the average American felt it yet? Generally, consumers feel the pinch of inflation, and reap the benefits from lower prices, on a lag. The reason is because the public are typically end users, or consumers.
When prices rise, retailers typically sacrifice margin before finally capitulating and passing on price increases to their customers. As such, consumers tend not to feel the effects of inflation until well into an inflationary cycle.
Businesses tend to discount only when it becomes abundantly clear they will not be able to sell unsold items at the posted retail price. For this reason, consumers often do not realize the benefit of slowing inflation until months after it begins to abate.
To that end, we believe shoppers will begin to notice lower prices on a growing number of items in relatively short order.