What We Learned About Inflation This Week
For younger investors, inflation has, until recently, been a kind of mythical beast from days gone by. Your parents may have warned you about it with tales of the terrible havoc it can wreak, but if you are under 50, you have probably never lived through it as an adult, and certainly haven’t experienced its effects firsthand. This week, however, a few things have happened that will have demonstrated the real problems of inflation, and it is worth noting them to make sure that investors understand the implications.
When prices are rising, low- and middle-income consumers are forced into decisions. Inflation usually follows periods of relative plenty, periods during which a large percentage of consumers have been able to have their cake and eat it too. They could pay for the essentials: food, shelter, energy, etc, but still have enough left to buy clothing, go on vacations, and renovate their houses or move. As prices rise faster than their income, however, that all changes and they have to make choices about what they do with the money, making sure they cover the basics first.
That is why both Walmart (WMT) and Target (TGT) in their earnings reports this week talked about the mix of sales last quarter more than spending overall. Both companies beat expectations on revenue, but fell short in terms of earnings as customers spent a larger percentage of their disposable income on the kind of essentials that are typically low margin, such as food. They spent more money, hence the revenue beats, but their money bought less, hence the choices.
That highlights the most basic thing about inflation: while it manifests itself as rising prices, at its heart, it is about the devaluation of currency. Once you understand that, it is easier to understand why the Fed is doing what it is and what to look for to show signs of progress. There is a lot of talk about the Fed deliberately targeting demand and thereby causing a recession, but that is more of a side effect than an actual policy goal.
What they are trying to do is to increase the value of the dollar by restricting its supply. We will know that is working when interest rates all along the curve start to go up of their own accord, rather than just at the short end because of the Fed’s actions. That will show that those holding dollars are demanding more to lend them out or, to put it another way, that demand for those dollars is outstripping supply.
Investors should therefore be looking at a generally higher yield curve as a sign that the policies are working, and as a signal to start buying stocks again. It is possible, if not exactly likely, that it could happen without a real destruction of consumer demand. If that turns out to be the case, then this what we're experiencing now will be just a blip with a quick recovery. Unfortunately, more likely is that the impact of tight monetary policy will linger and there will be a slow grind back but, even then, there will be some value in investing once the dollar’s real value stabilizes.
The other thing we learned this week about the nature of inflation is that it does not impact everyone equally. Even as value-driven stores like Walmart and Target reported worse than expected profit and market conditions, one retail company, Canada Goose (GOOS), did the opposite. The maker of high-end jackets and winter clothing beat expectations all around and issued upbeat guidance. That suggests that while those at the lower end of the pay scale in America are being forced into difficult choices about their spending, those at the other end are still comfortable with discretionary purchases.
That fits with one of the anomalies about inflation when looked at from the supply and demand pricing equation for the currency perspective. Usually, the price or value of something falling has a bigger impact the more of it someone possesses. That isn’t true of money, though, at least in terms of the impact of the dollar’s falling value on spending habits. If you have enough dollars, you are able to keep spending in the same way as prices rise. That is a positive for certain companies, but a negative for markets as a whole. The excess income from wealthy people is usually invested, and if they are spending more to maintain their lifestyle, they are investing less.
The point here is that, as those of us who lived through the seventies and eighties know all too well, inflation is about a lot more than just rising prices. It has pernicious effects on the poor and, by way of lowered investment, on markets. It will impact stock prices for some time to come, whether the Fed’s reaction to it causes a recession or not. That is why, from a long-term perspective, I will be looking beyond consumer numbers and watching for signs that the dollar’s value has stabilized before switching to a more bullish stance.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.