Where’s Waldo? Be On The Lookout For Rising Costs In A Low Growth World by Paul DiGiacomo, Columbia Management
- Broad measures of cost inflation (PPI and CPI) growth rates have remained near 2% for the past three years.
- Sharp increases have occurred in isolated areas like trucking, but the effect is far-reaching.
- Investors must be on the lookout for accelerating expense growth within a company or industry cost structure, as high inflation can lead to lower stock returns.
Over the past three years, Producer Price Index (PPI) and Consumer Price Index (CPI) growth rates have remained within a low band since the recession, despite the Fed’s massive liquidity injection (Exhibit 1). But, cracks in the façade are starting to show. With the modest recovery in housing, the move of manufacturing back to North America and the shale energy boom, the trucking industry is struggling to find drivers, given the industry’s low wages and poor quality of life: a typical long-haul driver returns home just five days a month.
Exhibit 1
Sources: Bureau of Labor Statistics, Bloomberg
As a result of below-trend wage growth (Exhibit 2) and the availability of better jobs, truckload carriers cannot seat their available tractors. Recent regulatory changes have reduced asset utilization — measured in miles per truck per week — and outside of pricing, the only way to increase revenue is through fleet growth. So, drivers will receive a 10% wage increase in the coming months, which the truckers will pass through to their customers with a 5%-6% rate increase just to maintain profitability.
Exhibit 2
Sources: Bureau of Labor Statistics, Bloomberg
Given the pervasive demand for truck capacity, these rate increases have had a far-reaching effect. For example, Eaton, a manufacturer of engineered goods, cited higher transportation costs in its data center business as a factor in the company’s disappointing margin performance in the second quarter. Further, Amazon, the internet retailer, is changing its distribution strategy to combat rising fulfillment costs, which jumped 30% in the first half of the year. Here, the company is moving from UPS and FedEx to their own trucks in urban markets, regional parcel carriers in the suburbs, and the U.S. Postal Service in rural areas in an effort to provide comparable service at a lower cost.
A benign inflation outlook suggests that revenue growth for most will come from volume, not price. As a result, companies in competitive industries must rely on productivity gains to offset persistent increases in operating costs. Similar to the Where’s Waldo? books, which challenge the reader to find Waldo in a sea of humanity, investors must be on the lookout for pockets of inflation within a company or industry cost structure, as research has shown that stocks with high cost growth tend to yield lower returns in subsequent periods*. Today, with global growth remaining quite modest and current margin run rates high by historical standards, that risk seems particularly acute.
*Huang, Jiang, Tu, Zhou, “Cost Growth and Stock Returns”, SSRN Working Paper, June 2014
