Inflation Expectations Are Not Well-Contained

By Dr. Duru written for One-Twenty

May 12, 2008

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"Inflation expectations are well-contained!" - this is the prayer that Ben Bernanke offers up five times every night to the gods of fiat currency. Unfortunately, slowly but surely, increasing oil prices are encouraging an inflationary mindset to seep into the nation's consciousness even as inflation is all too real in many parts of the global economy (I have earlier cited the double digit inflation rates popping up all over the globe). After struggling for months to get the credit crisis under control by drop-kicking interest rates to firesale levels, and after lending money with anxious abandon, the Federal Reserve is now almost sure to be rewarded with an inflation problem. If the Fed reacts by hiking rates back up all over again, it will crush America's debt-addicted economy before it is able to find a new equilibrium with the current state of credit liquidity. And the worst part? The Federal Reserve will likely be helpless to kill inflationary pressures anyway, at least in the short to intermediate term.

A lot of the building inflationary pressures are global in scope and have less and less to do with American demand. Some of the pressures are structural; after decades of under-investment, we suddenly find a world that is under-prepared to deliver on the resource needs of a wealthier and more aspirational global population. The U.S. economy has been under pressure for at least a year and this has done nothing to stop the steady march in the prices of a broad basket of commodities. The Fed continues to cross its fingers that a slow economy can keep a lid on inflation. The Fed also hopes the economy will next recover and quietly tip-toe around the slumbering beast of inflation. I think this scenario could be considered the close cousin of the "Goldilocks economy." For at least two years, I have written periodically about "slowing growth and persistent inflation" as a euphemism for stagflation, and it seems we are finally reaching the point of collective recognition of the problem. For example, for several weeks, CNBC has been running stories under the banner of "inflation nation." In CNBC's latest segment under this theme, CNBC guests and pundits try to answer the question "how long can the Fed be patient [with inflation]?"

Fueling an Inflation Crisis
Fueling an Inflation Crisis

In the U.S., oil is the major culprit contributing to an inflationary mindset. The relentless march of oil upwards has defied all expectations that any day now oil will reverse and go back to $70 or $80 (I think folks have finally stopped waiting for $40 and $50 oil to return). After scoffing at Goldman Sachs's prediction of $100 oil several years ago, folks now read Goldman's predictions of $150 to $200 oil with nervously knowing eyes. I think it is no accident that Federal Express (FDX) finally cried uncle soon after this report and lowered its earnings guidance again citing soaring fuel prices and a stubbornly weak economy:

"MEMPHIS, Tenn., May 9, 2008 ... FedEx Corp. (NYSE: FDX) today announced that earnings for the fourth quarter ending May 31, 2008 are expected to be in the range of $1.45 to $1.50 per diluted share, compared to the previous forecast of $1.60 to $1.80. Since we provided earnings guidance for the fourth quarter in March when the crude oil price was slightly above $100 per barrel, our estimated fuel costs for the quarter have increased more than 7 percent, or $100 million from our previous estimate, and the weak economy has restrained demand for U.S. domestic express package and LTL freight services," said Alan B. Graf, Jr., FedEx Corp. executive vice president and chief financial officer. "While we have dynamic fuel surcharges in place, they cannot keep pace in the short-term with rapidly rising fuel prices. This revised outlook assumes no additional increases to the current fuel price environment and no further weakening of the economy."

FDX is doing its best to hope against hope that inflationary pressures will soon cease. But note well that from this point on, more fuel inflation will further hinder profitability. Also note well that FDX has no expectation for a strong second half, just hopes that the economy does not get even worse. You can bet that all across the landscape of oil-sensitive industries, over-optimistic investors will begin to bid stock prices back down. Analysts will soon reluctantly scale back optimistic expectations for earnings growth in the second half. We still do not yet know how high gas prices need to get to impact significantly aggregate consumer behavior, but $4 gas may provide such a tripping point

Anyway bad news did not stop folks from buying up FDX stock after its dismal March earnings report. Back on March 20, 2008, FDX had the following to say:

"Our fourth quarter earnings outlook has been impacted by higher than anticipated fuel prices and a weak U.S. economy," said Alan B. Graf, Jr., FedEx Corp. executive vice president and chief financial officer. "Looking ahead to our fiscal 2009, we are expecting a continuation of fourth quarter trends, which would result in limited earnings growth next year. We are scrutinizing all expenses and investments to realign them with the current environment."

The stock opened down 3 or 4% but then proceeded to bounce 17% to its recent highs as the rest of the stock market began rapidly (and inexplicably) pricing in a sharp economic recovery. See the chart below:

Federal Express bounces after dismal earnings

This chart also shows us that 3 days of selling led up to FDX's latest warning. Resistance at the 200DMA held. Friday's selling was on high volume (not shown), and it broke important support lines formed by April's lows and the 50DMA. Bulls bought March's bad news, but they have met a rude awakening. FDX fell another 3% in Friday's after-market trading. While over-optimistic folks were buying stock, folks in the options pits were much more cautious. According to Schaeffer's Research, the FDX put/call ratio reached two-year highs in April that almost doubled the previous highs. This ratio was an astronomical 2.3! On Friday, intra-day volume on May puts soared to outnumber purchased calls by a ratio of nearly 9:1! May 90 puts traded 6360 contracts compared to an open interest of 11,916. I wish I had noticed that kind of action. Folks who try to out-think or over-think this stuff automatically assume a high put/call ratio is a contrarian indicator. In this case, as all this put buying finally led to stock selling and you received your early warning signal that something was wrong. Very wrong.

While FDX still is not yet speculating about increased inflationary pressures, we can see such speculation in the earnings conference calls of almost any commodity-related company. Steelmaker Cleveland-Cliffs (CLF) provided another great example. Here is's summary of the CLF earnings conference call on May 6, 2008:

"On conf call, co is explaining that some benchmark prices referenced in its contracts have yet to settle. All indications are that these 2008 increases will result in record price levels. As such, the co expects to recognize an additional $55 mln of revenue in a future quarter relating to tons sold in Q1 and almost all of this will flow through to the operating income line...Co is well positioned for price increases being seen in iron ore and coal... The price increase on some international business does not get included until this qtr, some was not reflected in Q1... Co also updates the sensitivity for the increase in steel pirces. Each $10 change from $700 per ton in the average hot rolled steel price results in additional realization of $0.24 per ton.... Co says it has still not seeing total global pricing gains because it has signed long term contracts which provide more certainty. However, the first of the contracts do start coming up for renewal in 2010 and they will start to be negotiated before then."

In other words, CLF is enjoying the benefits of inflation through increased profits, and the company is looking forward to even better results once they can unleash the full pressure on customers whose contracts soon expire. Inflation now and more inflation to come. And plenty of pricing power to boot. Make no mistake. These pressures are global, pervasive, and sustained. Consumers have yet to feel the full brunt of this inflation, but as soon as we see more corporate profitability hurt by this inflation, shareholders clamoring for performance will motivate companies to get these price increases passed along through the supply chain and finally into the lap of the consumer. Heck, look what the airlines are doing. They are putting restaurants on wheels in the aisles, charging to check-in a second bag, and who knows what's next! Those commercials where hapless passengers insert quarters to open the overhead bin may be more truthful than we thought...

Be careful out there...!

DR. DURU®, 2008