I was multitasking Tuesday. While listening to Chairman Powell discuss his expectations for price stability in the medium term, I was reading a press release from H.B. Fuller (a leading provider of adhesive solutions) that communicated the company’s intention to raise prices 5% to 12%. Apparently corporate America hasn’t gotten the memo explaining inflation is expected to remain stable.
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Michael Mauboussin: Challenges and Opportunities in Active Management And Using BAIT #MICUS
Michael Mauboussin's notes from his presentation at the 2020 Morningstar Investment Conference, held on September 16th and 17th. Q2 2020 hedge fund letters, conferences and more Michael Mauboussin: Challenges and Opportunities in Active Management Michael Mauboussin is Head of Consilient Research at Counterpoint Global in New York. Previously, he was Director of Research BlueMountain Capital, Read More
When developing my opinion on inflation, I prefer skipping the middleman (Wall Street economists and central bankers) and going directly to the source – businesses operating in real-time and in the real economy.
H.B. Fuller (FUL) is a good example of a company currently experiencing rising costs and implementing price increases. They are not alone. In fact, I thought H.B. Fuller’s explanation of its price increase was a good summary of the current cost and pricing environment for many of the companies on my possible buy list.
The past 12 months have seen continued increases in feedstock costs, logistics costs and labor costs. Inflationary pressures in global markets have occurred due to trucking shortages, Hurricanes Harvey and Irma in the United States, regulatory and environmental actions by the Chinese government, and robust demand. These increases will affect products in the company’s hygiene, packaging, durable assembly, construction, paper converting, and engineering adhesives segments.
Based on my bottom-up research, evidence of a tightening labor market, cost pressures, and pricing actions continue to build. Assuming corporate costs rise further and the Federal Reserve’s preferred measurement of inflation exceeds 2%, how will policy makers respond?
According to a recent Bloomberg article, instead of defending their target, the Federal Reserve may simply move it. Bloomberg explains, “Federal Reserve Chairman Jerome Powell and his colleagues may be willing to accept inflation rising as high as 2.5 percent as they seek to extend the almost nine-year economic expansion.”
If the Fed is willing to move its inflation target, why should investors assume it won’t move again? If inflation exceeds 2.5%, will policy makers move their target to 3%? And why not 4% or 5%? A slippery monetary slope indeed.
The bigger risk, in my opinion, isn’t if the Fed changes its inflation target or raises rates three or four times in 2018, it’s investors discover – as I have through my bottom-up work – that our central bank is falling behind the curve. In effect, as inflation moves through the pipeline, perceptions and investor psychology could suddenly change, causing the bond market to question the Federal Reserve’s ability and determination to confront rising prices.
While I believe an “inflation recognition” scenario is possible, investors do not appear very concerned. In fact, I recently watched an investment professional on financial television explain why inflation was good for stocks. And I thought the equity ownership justifications of TINA (there is no alternative to stocks) and FOMO (fear of missing out) were creative! What is next, trade wars are good for stocks too?
As the Federal Reserve debates inflation targets, companies aren’t waiting around for help with rising costs. Many are acting now. As H.B. Fuller’s actions illustrate, corporate pricing decisions are based on what businesses are experiencing, not an arbitrary and possibly fluid central bank inflation target.
It’s a tricky time to be an investor in stocks and bonds. In my opinion, to justify current equity valuations and experience further gains, stock investors need perpetually low interest rates and a stable bond market. While ideal, is such an environment possible considering rising equity prices would be stimulative, leading to additional inflationary pressure and higher interest rates? On the other hand, bond investors (ex junk) would likely benefit from stock market instability, sharply lower stock prices, and the economic drag it would bring.
Although stocks or bonds may rise in the near-term, if inflation targets and trends become unhinged, I believe many of the assumptions used to justify owning stocks and bonds would be challenged. In such an environment, the days of indiscriminate asset class inflation (everyone wins) would likely come to an end – a victory for capitalism and free markets.