During the June press conference of the Federal Open Market Committee (FOMC), Federal Reserve Chair Janet Yellen downplayed the recent slowdown in inflation. She even went so far as to call attention to cell phone service pricing as a temporary factor affecting inflation expectations.
Fed watchers had started to doubt whether the central bank would further increase rates this year as inflationary pressures ebbed. Yellen's statements sent rates on the 10-year Treasury plunging as most see little evidence that the Fed will be able to reach its inflation target of 2% this year.
But what if Yellen is right? What if pricing pressures are heading higher?
A return to inflation after years of subdued pressure would have far-reaching effects on the economy and different assets. Not only would increased inflation send bonds reeling, but it could also derail the eight-year bull market by slowing price growth via higher interest rates.
With the unemployment rate nearing 4% and economic growth pulling people back into the labor force, the Fed is firmly in disagreement with the market on the outlook for inflation.
Only one of them can be right.
So Who Is Right?
The markets do not seem to buy Yellen's June 14 view that weak inflation data is a temporary and artificial phenomena. The rate on the 10-year Treasury fell from its 2017 high of 2.6% to just 2.14% after the meeting on expectations that low pricing pressures will keep the central bank from raising rates as quickly as expected.
Wage and other inflation data have come in slightly lower than expected over the past several months. Average hourly earnings have grown at a 2.5% pace this year through June, while the Fed's measure of inflation, personal consumption expenditures, has only posted above the bank's 2% target in one quarter since the end of the recession.
But Yellen and other Fed members have been quick to point out temporary factors holding inflation lower, such as a price war between cell phone carriers. An unemployment rate of 4.4%, the lowest point since 2001, should theoretically lead to faster wage growth as employers compete for workers.
Data out last week may support the Fed Chair's outlook, with global food prices spiking to a two-year high. The United Nations Food Agency reported global meat prices up 10% from a year ago, while the price of butter has increased 8% in a month. Crop yield concerns have cause the price of wheat to jump by 4% over the last month.
The number of people from outside the labor force, those previously counted as not looking for work, that became employed jumped to 4.7 million for the year. That's the largest increase since data collection began in 1990 and shows that people aren't having to wait to find a job after reentering the labor force but immediately getting work.
That's a very tight labor market and suggests that wages could push higher as employers compete for workers.
Other central banks, including the European Central Bank, the Bank of England, and the Bank of Canada, have all been talking about the prospect for higher rates and less accommodative stimulus on recent strength in economic growth and prices. The news has sent bond yield higher, with the ten-year rate reaching 2.38% last Friday.
Who Wins From Yellen's Inflation Trade?
If Yellen is correct in her outlook for inflation, it could catch much of the market off guard. Faster inflation growth and the potential for higher rates could drive bond prices lower and damage earnings expectations for companies that aren't able to pass higher prices along to customers.
Companies in the agricultural space could see a boost to revenue and investor sentiment. Commodity prices are some of the first to increase in an inflationary environment, with agricultural producers and other farm-related stocks benefiting immediately.
The Mosaic Company (NYSE: MOS) could see an increase to crop nutrient prices as agricultural prices increase. The company's North American mines give it a low-price advantage over many competitors and shares trade for just 0.8 times book value, well under its average 1.5 times multiple over the last five years.
The company reported disappointing first-quarter earnings on lower margins and volume. The news sent the shares down 8% and investors gave management no credit for maintaining full-year guidance. This could lead to a relief rally even if prices do not get a boost from higher inflation.
Archer-Daniels Midland (NYSE: ADM) could see increased revenue from multiple sides of its business. It should be able to pass crop price increases through to food manufacturers and could book a higher profit on crops it bought previously at lower prices and held in storage.
The company's strong trading desk could also see increased profits as it benefits from arbitrage opportunities, buying crops in regions where inflation has already increased prices and selling in others. Shares trade for 1.4 times book value, just over the average multiple of 1.3 times over the past five years but well under the average 1.7 multiple on industry peers.
Financials, especially banks with a large lending business, could see increased return on equity as inflation pushes up long-term rates. The yield curve has been frustratingly flat because of low inflation expectations, leading to little profit in the difference between deposit rates and long-term lending rates.
Zions Bancorporation (Nasdaq: ZION) is one of the best-positioned regional banks to benefit from higher interest rates. The bank has avoided making longer-term loans and investing in long-term bonds in the low-rate environment. Instead it has held a high cash-to-deposits level and invested in shorter-term bonds. These moves have left the bank with a lot of financial ammunition for increased lending if rates pick up.
Zions has invested heavily in its IT systems as part of a multi-year efficiency program. Management plans on cost savings of $120 million through this year through operating efficiencies and consolidation in processing centers. That could boost profitability even as higher rates send lending revenue higher.
Risks To Consider: Low unemployment and moderate economic growth have yet to come through with higher inflation and it may be several months before prices head higher. Economic growth should support stock prices but be ready to wait out the theme before Yellen is proven right or wrong.
Action To Take: Position in stocks of companies that will be able to pass pricing pressures through to customers to protect earnings from higher inflation. The names I mentioned above are a good start.
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