Inflation contagion
Inflation is rearing its head again, and this time it may hurt corporate profits. Crude oil is marching to new records, gold crossed $800 an ounce for the first time since 1980 and the dollar is almost daily hitting new lows against the euro.
The Federal Reserve said last week that there is roughly as much risk of rising inflation as economic weakness. Several economists think it will likely hold interest rates steady to keep inflation at bay.
Inflation erodes the value of most bonds because they pay a fixed rate of interest, but as a hedge, investors can purchase inflation-protected government bonds or mutual funds. Inflation’s effect on stock returns is not as clear-cut.
The Consumer Price Index has been rising for five years, but companies have largely shrugged it off amid strengthening demand. That may soon change.
Since 1929, during periods of rising inflation, stocks have returned just 1 percent more than cash annually. The differential was 9.5 percentage points annually when inflation rates were falling, according to Wachovia economist Gina Martin.
“Margins may be the No. 1 target in the year ahead, particularly as demand continues to slow in the United States,” Martin says. “In the end, it appears margins have either peaked or are very near peaking for this business cycle, and inflating prices are likely to force margins a bit lower in 2008.”
Citi Investment Research analyst Lori Calvasina also suggests profit margins will weaken in 2008’s second half, due to a diminished ability to raise prices and rising labor costs, based on a survey by the National Federation of Independent Business.
Periods of weak margins have historically favored growth over value stocks, she says.