The latest inflation numbers for the U.S. were reported on Thursday, Nov. 10. The results were positive overall, as inflation fell from 8.2% in September to 7.7% in October, the lowest level since January 2022, according to the CPI. This is significantly lower than the 40-year high of 9.1% reached in June 2022.
However, this inflation rate is still significantly higher than the Federal Reserve's long-term target of ~2%. Not all is rosy just because of one slightly better than expected inflation report. Thus, in this article, I'm going to dive deeper into the types of inflation and what this recent report really means for investors; let’s dive in.
What is inflation?
To begin, let's recap on the basic definition of inflation. Inflation at its core is when prices increase. In the U.S., the favorite inflation measure of the Fed is the CPI (aka the Consumer Price Index), which analyzes the price changes in a basket of everyday goods from gasoline to food and shelter.
Rising energy costs have been a key inflation driver, as energy inflation increased by an eye-watering 17.6% in October. This was mainly driven by high gasoline prices (up 17.5% year-over-year) and electricity costs (up 14.1%). Because gas is necessary for transportation, this had a knock-on effect on food prices to add to the pressure of the global droughts.
Energy prices are correcting
Oil prices were extremely cheap and actually went negative during the pandemic lockdowns of 2020, as people travelled less often and worked from home when they could. Oil was in abundance and many facilities had a lack of storage for it.
I personally saw this as a temporary issue and loaded up on oil stocks such as Shell (SHEL, Financial), BP (BP, Financial) and Chevron (CVX, Financial). At the time this was a highly contrarian investment, as growth stocks were all the rage in 2020. However, as the economy reopened, travel had a major rebound. Then the Russia-Ukraine war began, and the resulting wave of Western sanctions on Russian energy exports caused oil prices to skyrocket to over $100 per barrel on the WTI index.
However, as oil prices are now beginning to correct, this is serving as a powerful force behind inflation going down as well. As a result, I took profits on the aforementioned oil stocks and generated returns of over 95%, as I have a high conviction that the bull run for oil stocks is coming to an end. After all, energy is a highly cyclical sector.
The Russia-Ukraine war that started in February 2022 continues to affect supply volatility and energy security in Europe. The Nordstream pipeline which connects Germany to Russia has been the result of a series of attacks. In addition, manufacturing powerhouse Germany gets ~34% of its oil from Russia, and the fear that Russia may turn off the tap has kept energy prices elevated in Europe. However, the panic has subsided a lot in the U.S.
Fears of a “cost of living” crisis across many parts of Europe have caused some governments such as the U.K. to offer energy subsidies to its citizens. Luckily, the beginning of the colder seasons in the U.K. has been surprisingly mild so far, with temperatures of 60.8 degrees Fahrenheit in November. This has helped to not further exasperate the energy crisis.
The other CPI components
Aside from energy, the CPI index is also made up of everyday goods such as food products (bread, milk, etc.) that have their prices tracked. In the recent CPI report, food inflation increased by 10.9% in October, which is fairly high but less than the 11.2% increase in September. Many consumers are now beginning to choose cheaper products at the grocery stores as a result, such as Supermarket branded products as opposed to those with a brand name.
Shelter prices are also tracked by the CPI, focusing on rent as home prices are considered too volatile for the CPI. In October, prices for shelter increased by 6.9%, which was greater than the 6.6% reported in September. However, this is a lagging indicator as it considers rents renewed a year ago just as much as rents renewed last month.
Demand-pull inflation
There are three main types of inflation: demand-pull, cost-push and built-in. The most obvious type is demand-pull inflation, which basically means high demand and/or short supply of goods, which in turn drives up prices. You can think of this as “too many customers chasing too few goods."
We saw this type of inflation during 2021, as the sleeping economy woke up and demand for goods soared. The semiconductor shortage of 2021 was a key example of this, with high demand and slow supply causing higher prices. The chip shortage mainly affected the automotive sector, which operates using a “just in time” approach to manufacturing. This lean manufacturing style works well when supply is abundant, but during volatile supply/demand changes, it can lead to issues. When forced to choose, the suppliers of manufacturing chips also preferred to sell chips to higher-margin industries as opposed to the lower-margin automotive industry. Then of course, we have the growth in the electric vehicle sector, which has further increased the demand for chips.
We also saw a similar supply/demand issue with lumber in the U.S. between August 2021 and January 2022. Lumber prices increased from $400 to over $1,400 over this timeframe, which was astonishing. This was because lumber manufacturers shut down facilities or slowed production in 2020 before housing demand surged and supply couldn’t keep up. The aforementioned rise in energy prices can also be seen as a type of demand pull inflation.
Cost-push inflation
Cost-push inflation is a more dangerous side effect of demand-pull inflation in many cases. Basically, this is when the input costs for businesses start to rise and they must in turn raise prices for consumers.
Not every business has the pricing power to do this as it may make the business lose out against the competition. A company such as Apple (AAPL, Financial) has solid pricing power thanks to its strong brand, which means people are willing to pay more for Apple products than equivalent products from competitors. However, most businesses don’t have this pricing power and may see their margins and earnings get squeezed during a high inflation environment. If they raise prices faster than the competition, it could make them lose market share.
Expected inflation, which is adjacent to cost-push inflation, can be extremely dangerous. Expected inflation is when companies are expecting an increase in their input costs so they raise their prices prematurely and/or more than necessary. This can cause a vicious cycle of increasing costs, which Fed Chairman Jerome Powell warned against at his Jackson Hole speech.
Built-in inflation
Built-in inflation follows on from the aforementioned inflation types. If businesses raise their prices, the consumer gets squeezed with higher costs and then asks for higher wages. Ideally, built-in inflation should be the same across the board in order to support a healthy economy. We have seen labor shortages due to deaths from the pandemic as well as companies not offering attractive enough wages.
What this means for investors
So what does all of this mean for investors? Lower inflation is positive for the majority of investors overall as it means lower input costs for businesses, higher margins and consumers having more disposable cash to spend. However, inflation has only fallen from the 8.2% in September to the 7.7% in October. It still remains elevated and is well above the Fed's 2% target.
Many investors have diversified their portfolios into inflation hedge assets such as oil stocks and real estate. I personally believe this to be a solid strategy, but holding undervalued growth stocks could also be a strong strategy in the long term. It could take at least six months or more for inflation to fall to tolerable levels, and only then could we see the Fed start to lower interest rates.
When the market expects the Fed to start to lower rates, I project a vast amount of inflows into growth stocks as lower discount rates elevate the value of future cash flow estimates. Even on this recent news of inflation, which really wasn't that great, many growth stocks have popped in share price. Amazon (AMZN, Financial) gained 12%, Alphabet (GOOG, Financial)(GOOGL, Financial) was up 8% Netflix (NFLX) was up 8% in the past 24 hours. However, we are not out of the woods yet, and inflation still has long way to fall before we can expect any loosening of interest rates.
Final thoughts
Inflation is an economic component that has caused a series of knock-on effects which has decimated the stock market this year. The good news is the economy has been through inflationary periods in the past, such as in the 1970s, and has come out of the other end ok. Fed Chairman Jerome Powell aims to chock inflation out through a series of tough interest rate hikes. This is expected to hurt consumers, businesses and stocks in the short term. However, this strategy is working so far and inflation is falling. In the long term, this is what the economy needs to achieve lower inflation levels, although I forecast a 3% to 5% baseline going forward as opposed to the pre-pandemic levels of 2%.
