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Inflation On The Horizon


The manufacturing and service sectors of the economy continued to expand in January according to the surveys from the Institute for Supply Management. The non-manufacturing survey jumped 7.7 points to 65.7, which is the highest value since the survey was started in 1997. It was also the tenth consecutive month that the index signaled an expanding economy. The increase was driven by a 5.4 point jump in new orders. The increase put the new orders index just 0.8 points below the high of 64.9 set in August 2003. Supplier deliveries were also strong, increasing 4.5 points to 56.5, the highest level since May 2000. An increase in supplier deliveries means that supply chains are slowing down and it is talking longer for companies to receive inventory. Perhaps not surprising, inventories lost 2 points to 49.5, showing. Inventory had increased the previous two months and was the only component which was under 50 indicating contraction. All the other components fell in January, but remained over 50 signifying expansion.

The prices component fell 0.6 points to 59.7. The report provided a list that respondents reported were increasing in price:

Price increases are reported for aluminum and aluminum sheet; asphalt; automotive parts; bearings; beef; blood; chemicals; chicken; copper; dairy products; #2 diesel fuel; food; truck freight; fuel; furniture; gasoline; #2 heating oil; medical and surgical supplies; natural gas; office products; polyethylene; plastic; pork; PVC conduit and PVC pipe; soy oil; steel; steel coil; steel pipe; and unleaded gasoline. Aircraft parts; beef; computer equipment; and surgical drapes and gowns are reported down in price.

The manufacturing survey increased 0.2 points in January to 63.6 from December, the highest value since December 1993. The individual components that make up the manufacturing survey were more varied than the non-manufacturing survey. The manufacturing survey had three components that were over 70, new orders, production, and prices. It also has two in the forties, inventories and consumer inventories. Production increased by 1.9 points to 71.1. This was the first month since December 1983 that production surpassed 70. In fact, the production component has only been above 70 seven times in the past 40 years. While new orders declined by 2.0 points, it was still was above 70, which indicates strong expansion. January was the third consecutive month that new orders topped 70. Similar to the non-manufacturing survey, delivery times are getting longer. The supplier deliveries component rose 1.8 points to 60.4. The last time companies reported an increase in delivery times of this magnitude was in February 1995. Manufacturing inventories contracted and customers' inventories were reported being too low. The prices component registered the largest increase. It jumped 9.5 points to 75.5. This was the highest level since March 2000 and the largest increase since March 2002. Just like in the non-manufacturing report, the ISM included a listing of commodities that were up and down in price:

Commodities reported up in price are: Aluminum; Aluminum Extrusions; Brass; Cobalt; Coke; Copper; Electronic Components; Energy; Ethylene; Freight; Fuel Oil; Gasoline; Natural Gas; Nickel; Polyethylene; Polyethylene, Film; Propylene; PVC; Resin; Scrap Iron; Soybean Oil; Stainless Steel; Steel; Steel, Bar; Steel, Galvanized; Steel, Hot Rolled; Steel Sheet; and Sulfuric Acid. The commodities reported down in price are Caustic Soda; Corrugated Cartons; and Linerboard.

I'm just glad there is no inflation, otherwise just think how long that list could be.

Several economists have proposed that companies will not be rebuilding inventories to previous levels. The "just in time" inventory model has been universally accepted and implemented. Without debating the merits of "just in time", it is likely that it might lose some of its luster if prices continue to increase. If prices continue to rise there will be an advantage to ordering early and holding inventory. Companies will weigh the cost of additional storage versus paying more latter because of rising prices. It has been a long time since companies were faced with the challenge of managing inventories during times of raising prices. Plus, the extended delivery times that the ISM surveys indicated will necessitate stockpiling more inventories to avoid depleting inventory while inventories are in transit.

Prices have started to increase in the back-end of the economy. In addition to the survey results from the ISM , commodity prices have been rising steadily for over two years. The year-over-year change in the producers price index has been greater than the change in the consumer price index since February 2003. Incidentally, The disparity between the year-over-year change in the producers price index and consumer price index is the highest since June 1975 when it was 350 basis points. At that time, the change in PPI was 12.9% whereas the change in CPI was 9.4%. On a relative basis PPI was 37% higher than the CPI. While on an absolute basis the discrepancy was higher than the current difference of 210 basis points, the difference is really much larger since the PPI is over twice what the year-over-year change in CPI. Maybe rising prices will even show up in the CPI one day.

I have been spending a significant amount of time lately describing an expanding economy. The pace of economic growth has started to cause some stress in the economy as evidenced by increasing prices and longer delivery times. Last week, the Commerce Department announced that the economy grew at an annualized rate of 4.0% during the fourth quarter of 2003. While this was less than half the rate of the third quarter and below what most economists forecasted, it is still above what is typically considered sustainable long-term growth. Also, the nominal year-over-year growth was measured at 5.9%. This was the fastest growth since the third quarter of 2000. The fast pace of economic growth has helped drive corporate revenues and earnings as well. First Call estimates that revenue for the S&P 500 increased 9.3% in the fourth quarter. That would make it the third quarter of the past four that revenues grew at 9.0% or better.

The expanding economy provides a tailwind to companies. Unfortunately for investors, stock prices have already been bid up to levels that underlying fundamentals might not warrant. Investors are left playing the expectations game, which is usually difficult and dangerous. According to First Call, the S&P 500 grew earnings during the fourth quarter by 26.2%, which is more than five percentage points better than was expected. It is interesting to note that estimates for the current quarter have not increased very much. Since the beginning of the year, analysts have increased their earnings growth estimate by 30 basis points to 13.4% (this excludes the results from Lucent. Lucent had a large charge last year that distorts the year-over-year growth). The S&P 500 has declined 2.5% from its peak last week. The lack of optimistic guidance from companies has been reason mentioned. It will be interesting to see if analysts start raising earnings estimates later in the quarter. It that happens, that could be the catalyst for the market to advance further. If not, investors will have to start asking if they really want to be paying 18 times earnings when earnings are only forecasted to grow only around 13%. Investors are also left wondering when the Fed will begin raising interest rates. Given the pace of economic growth, the Fed should have already started tightening monetary policy. It will get interesting when the Fed finally tightens.

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