DISINFLATION WITH A HIGHER RISK OF DEFLATION THAN INFLATION

David Rosenberg had some succinct thoughts on the continuing inflation/deflation debate this morning. He cuts right to the heart of the argument noting that, because end demand remains weak, we are still at a higher risk of deflation than inflation:

There is no more significant source of inflation than the U.S. labour market and we found out on Friday that total employment costs slowed to just +0.4% in Q3 and the YoY trend is extremely tame, at +1.9%. Wages came in at +0.3% sequentially and just +1.5% on a YoY basis.

We can understand the temptation to believe in the inflation story because of what the CRB index has been doing, but our advice is to resist that temptation and remember what we were talking about, quite unexpectedly by the way, six months after oil hit $140/bbl back in 2008. Deflation.

In many cases, pricing power is hard to achieve and so the bump in commodity costs serves as a margin squeeze as opposed to a sustained source of final stage inflation. For real-life examples as opposed to the data, what did the NYT have to say about Colgate’s profit results? This — “Colgate’s revenues in the United States, which produces 19% of its sales, grew 2%, while the company sold 3% more products. Price cuts reduced earnings in the United States by 1.5%.”

This is important because a lot of investors prefer to just look at commodities as evidence of impending U.S. inflation. This is partly misguided for several reasons. First of all, there are many variables influencing commodity prices at any given time. Currently, I would attribute the move in commodities to Asian strength (there is very real inflation in much of Asia ex-Japan), fears of U.S. “money printing” and the rise of the commodity investment class. Except for the case of “money printing” (which I believe is largely the result of misunderstanding how our monetary system works) there remains little worry of these variables influencing U.S. consumer inflation. As Mr. Rosenberg highlighted, there is only so much commodity price inflation that a weak U.S. consumer will allow (reference 2008).

The rise of the commodity investment class has largely created a hedging mechanism for investors and this component of the commodity price increase represents a “bet” that inflation is coming. Gold is generally the oft cited “inflation” hedge. But gold prices merely represent a “bet” and not necessarily a reality.

Perhaps the most interesting component in this debate is the margin compression story. Ultimately, because we are in a debt delevering cycle, a labor recovery will precede inflation in the U.S. With rising input costs margins are likely to become compressed. This will actually put downward pressure on inflation as corporations fight to sustain high margins and the labor markets suffer as a direct result. Therefore, I agree with Mr. Rosenberg and still believe we are living in a world of disinflation with a higher risk of deflation than inflation.

Source: Gluskin Sheff