Gauging Inflation and Its Effect on Stocks

by David Urani

In my eyes, inflation is the number one story in the markets right now, so now that we have both the PPI and the CPI for January, it's time to do some analysis on the latest trends. Inflation poses a real risk to corporate earnings, but the more companies are able to pass on the costs, the better off they will be. Therefore, when measuring inflation's potential effect on stocks I like to look at how much consumer costs are increasing versus producer costs. Calculating the difference between the CPI and the PPI, particularly for "core" prices (excluding food and energy), yields a good correlation with stock prices, as we show below.

The Producer Price Index rose by 0.8% in January, which was slightly lower than December's 0.9% increase, but still elevated; the Street was looking for another 0.9% increase; core prices increased by 0.5% compared to the 0.2% consensus and increased by the most since October of 2008. The big obvious driver was energy costs, with upward pressure on the core index coming from rubber, chemicals, and metals, among others.

The consumer price index ran at a 0.4% increase in January, matching December's increase and falling above the 0.3% consensus estimate; core prices increased by 0.2% versus the 0.1% consensus. The headline index was boosted by a 2.1% increase in energy, including a 3.5% increase in gasoline. Food also rose by 0.5%. With respect to core prices, apparel was up 1.0%, airline fees were up 2.2%, and medical commodities were up 0.5%.

Once again, core consumer prices lagged producer prices. The core "inflation spread" (CPI minus PPI) decreased to 47.1 from 47.6. This is the lowest the spread has been since it hit the same level September, and the last time it was below that was back in April 2009. This tells us that producers are not fully passing through the increases in input costs, and you can't blame them, as consumer demand is still relatively elastic (sticker price increases are met with consumer backlash) amidst high unemployment. Consequentially, it looks like the first quarter of 2011 is shaping up to be a little more difficult on the pricing side, particularly for consumer stocks. Click on chart to enlarge: