Executive Summary
In addition to the massive rise in gas prices, almost all goods and services (see first graph) have seen significant price increases, resulting in consumers changing spending habits. The reduction in consumer demand will have a negative effect on corporate profitability (see 4th graph). COVID 19 stimulus provided a sugar high to corporate profits, and now producer prices are rising faster than the Consumer Price Index (5th graph). This means corporations are not able to fully pass along increased costs which reduces profitability. With first quarter 2022 GDP negative, some speculate we are already in recession. Even with stock market drops this year, stock valuations are still higher than the 2000 Tech Bubble (see last graph). High inflation is affecting everything.
Please proceed to The Details.
“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”
–Ronald Reagan
The Details
Anyone who has filled their car up with gas or been to the grocery store lately has noticed the dramatic rise in prices. Gasoline is now pushing $5.00 per gallon. According to an article on CNBC.com, “The cost of meat, poultry, fish and eggs is 13% higher since February 2021. Fresh fruit has gone up 10.6% in price in that time, while the price for vegetables has remained much more stable, increasing just 4.3%. The price of pre-packaged cereals and baked goods has increased 7.7%.” The graph below shows the increases in the Consumer Price Index (CPI) and the national price of gasoline.
Unfortunately, the drastic increase in prices is causing people to alter their spending habits. For lower income households, the impact of such prices is more severe. As stated in an article on Forbes.com,
“Global enterprise technology firm Morning Consult found 16.5% of U.S. adults weren’t confident in their ability to pay their monthly grocery bill in March 2022, compared to 8% in March 2021.
For households with incomes under $50,000 annually, that uncertainty rose to 19%. The research arm of grocery giant Kroger reported in April that more than half of consumers are cutting back on snacks and candy at the grocery store, and about half are buying fewer drinks like soda or juice. Shoppers are also cutting back on fresh bakery items, as well as hair products and cosmetic items.
In the most severe cases, households may be making considerable sacrifices due in part to the rising cost of food, like picking and choosing which bills to pay on time each month.”
In order to combat inflation, the Federal Reserve Bank (Fed) has announced plans to reduce the assets on their massive – almost $9 trillion – balance sheet and raise the short-term Federal Funds interest rate (FFR). The reduction in their balance sheet officially begins this month (June). See the graph below.
The Fed has already raised the FFR by 0.75%. They have announced they will likely increase the FFR two more times, by 0.5% each, including once this month. After that it depends upon the status of inflation.
As already shown, the extreme increases in prices are beginning to affect household spending habits. Slowing consumer demand will impact corporate profitability and overall economic growth. In addition to the impact on goods and services, the housing market is getting hit with 30-year mortgage rates jumping to around 5%. See a graph of rates below. A reduction in housing sales will further reduce consumer spending on goods and services such as furniture, fixtures, remodeling, etc.
Corporate profits, which were beginning to suffer in 2019 and into the pandemic, received manna from heaven in the form of incredible amounts of Federal stimulus. Both direct stimulus through PPP (forgivable loans) as well as through the benefit of soaring consumer spending fueled by stimulus received by households. These “gifts” gave the appearance that corporations had recovered, and profits would continue to soar. A miniscule amount of research would have revealed the temporary nature of this sugar boost provided by Uncle Sam. Notice the surge and now downturn in corporate profitability in the chart below.
The situation for corporations is more serious than many realize. The graph below reveals a critical problem for companies. Profit margins, which had expanded beyond the norm, are now being dramatically squeezed. Notice below how input costs illustrated via the Producer Price Index (PPI) in blue have increased far more than the CPI in red. This means that corporations are not able to pass through the full increase in their costs. As corporations eat a significantly higher portion of their input costs, their profit margins; and therefore, net income will be reduced.
Falling corporate net profits due to a drop in demand combined with lower profit margins will put downward pressure on economic growth. GDP growth already dropped to negative territory in the first quarter 2022, falling 1.5% on an annualized basis versus the fourth quarter 2021. Second quarter estimates have been steadily lowered causing some to speculate whether a recession has already started.
The demand destruction caused by inflation, especially energy costs, combined with squeezed profit margins and overall weak economic growth is putting downward pressure on the stock market. Remember, stock prices should ultimately represent the present value of a long-term stream of corporate cash flows. The massive bubble in stock prices is becoming more evident with rising interest rates and falling profits. As they say, it is only when the tide goes out that you learn who has been swimming naked. There are currently many highly priced non-profitable companies.
As such, the stock market has already fallen close to 15%. The drop has been more severe for the NASDAQ which includes the high-flying tech stocks, now down closer to 25% from its recent high. Yet even so, The Buffett Indicator (shown below) reveals valuations remain higher than the previous record high logged during the Tech Bubble of 2000.
The “unexpected” rise and sustainability of inflation as described by the Fed is rendering a severe blow to consumers and corporations. Consumers are forced to prioritize their spending and cut-out some discretionary spending. Corporations are feeling the squeeze as input costs rise higher than they can pass through to consumers. Lower profits and slowing growth could be sending the economy into recession. And, despite it all, the stock market remains extremely overvalued, only surpassed by the prior Tech Bubble of 2000. The spillover effects are serious.
The S&P 500 Index closed at 4,109, down 1.2% for the week. The yield on the 10-year Treasury Note rose to 2.96%. Oil prices rose to $119 per barrel, and the national average price of gasoline according to AAA increased to $4.85 per gallon.
© 2022. This material was prepared by Bob Cremerius, CPA/PFS, of Prudent Financial, and does not necessarily represent the views of other presenting parties, nor their affiliates. This information should not be construed as investment, tax or legal advice. Past performance is not indicative of future performance. An index is unmanaged and one cannot invest directly in an index. Actual results, performance or achievements may differ materially from those expressed or implied. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy.
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