Inflation vs Deflation: How you can have Both at the Same Time

This week’s economic data from the US shows how you can have two market forces in play at the same time that seem to be contradictory to each other and here is why. You can have inflation based on energy and commodity pressures and deflation in consumer pricing at the same time based on lack of demand and shoppers wanting better value because of one of the positive fundamentals that is driving stock markets higher, and that is the record margins that corporations are enjoying. Margin, which is the difference between input costs and the selling price, allow the producers of consumer products to absorb the inflation without passing it on to the consumer. Additionally the very healthy cash positions of corporations will allow them to survive in this period while keeping consumer prices low and absorbing costs. That is of course until it reaches a point mid-year when the costs will be passed on which will lead these two opposing forces to move together higher leading to accelerated inflation regardless of demand, with the move being exaggerated if demand surges.

Margins are a result of productivity gains during the cost cutting phase that dominated the markets performance during 2009. These savings are what are leading to revenue misses and earnings blowouts, but as the two forces of inflation and deflation are squeezing this margin it will impact earnings going forward and will lead to earning misses in 2010 starting in the first quarter for many in the S&P 500. Many companies like Cisco have been showing huge margins based on year over year costs, others like Dell are already feeling the squeeze because of their assembly model, Dell does not manufacture a majority of their components so they feel the PPI inflation before pure product manufacturers do.

This is something I think many are missing, they are not watching how margins are going to be impacted this year, which impacts earnings, which impacts stock valuations. So be aware of people picking to look at the CPI over the PPI or vice versa, because they need to be used together with other factors to truly understand what they are signaling.

PPI and CPI Data from http://www.bls.gov