Inflation: Old School Analysis, Novel Market Pricing

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Inflation: Old School Analysis, Novel Market Pricing

We did a call today to a group of investment professionals who operate all the way from venture capital to public markets, and the topic of inflation was a prominent piece of the Q&A. We’ve been writing about this for a few months now, but the conversation led us down some paths we want to explore with you today.

First, let’s go old-school and think about inflation through the lens of corporate pricing power. Any industrials analyst will tell you that a sector needs high levels of capacity utilization before companies can raise prices. If a business tries to raise prices while its competitors still have plenty of open capacity it will lose market share (at least temporarily) and the price increase simply won’t stick.

The magic number is right around 80 percent capacity utilization, and the following chart back to 1980 shows just how rarely American manufacturing has hit that level since the Financial Crisis. About the best it got was 79.6 percent in November 2018, and that did not last long. Prior cycles (1987 – 1990, 1992 – 2000, 2005 – 2007) had long runs of +80 percent capacity utilization. No wonder we’ve had structurally lower inflation since 2000.

Now, you could reasonably say “the service economy is what matters now, not manufacturing”, but services work similarly when it comes to pricing power and the barriers to entry are usually lower than manufacturing. Think of all the restaurants and bars that have opened up in your hometown in the last 10-20 years. That’s incremental capacity. Yes, many of these places shuttered last year but the physical space is still there waiting for a new operator. And for larger services companies – e.g., banking/finance, legal, health care – technology allows them to scale more efficiently than ever before.

Takeaway: an expected post-pandemic surge in consumer demand is the crux of the inflation story just now. For it to generate real, lasting inflation it will need to push the US economy’s capacity utilization past any point in the 2010s and keep it there for some time. Possible? Sure. Likely? We remain skeptical for now.

Second, let’s compare that analysis to what markets are actually saying. It is, as the chart below of 5- and 10-year TIPS inflation breakevens shows, very much worried that inflation will shortly be upon us. These sit at 2.54 and 2.27 percent (and were up slightly even today). You have to go back to 2007 to see higher 5-year inflation breakevens and 2013 for 10-years. Both were, importantly, periods of high or at least fast-rising capacity utilization.

Takeaway: markets have made up their mind and strongly believe that inflation is coming even though it is hard to justify that concern using the sort of fundamental analysis we’ve shown you today. From an investment standpoint, it hardly makes a difference because Treasuries still pay so far below even modest inflation expectations. You don’t have to believe those TIPS breakevens to justify selling long-dated bonds, even here.