The Investment Implications of Food and Energy Inflation

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Following a solid jobs report last week, investors this week will turn their attention to inflation which, to say the least, has been more of a problem this year.?We expect this Friday’s CPI report to show a 0.6% increase in prices overall and 0.4% excluding food and energy.?On a year-over-year basis, we are looking for headline inflation to fall from 8.2% to 8.1% and for core inflation to drop from 6.1% to 5.7%.

Economists and the Federal Reserve may take some comfort in the small easing in core inflation.?However, the report should also show the biggest gap between year-over-year headline and core inflation seen since 2008, with food prices up roughly 9.4% and energy prices up 33.4% relative to a year ago.?This is important, as it implies a much tougher inflation problem for lower-income households, could result in lower consumer spending on other basic goods and services and, by pummeling consumer confidence, increases the risk of recessionary psychology taking hold.?

For the most part, high food and energy prices reflect the results of the pandemic, the fiscal policy response to the pandemic and the war in Ukraine.?As these shocks to the global economy fade and high prices increasingly spur production and stifle demand, both food and energy prices should ease.?However, there continues to be a risk that the Federal Reserve feels obliged to aggressively tighten to speed the decline in inflation, potentially tipping the economy into a recession to fight an inflation problem that was going to fade anyway.?Either way, investors should hesitate to make a long-term bet on rising or even sustained inflation at these levels.

In recent decades, whenever the United States has seen a spike in inflation, the most likely culprit has been oil.?And, indeed, crude oil prices are high, with the spot price of a barrel of West Texas Intermediate Crude selling for $101.78 in April, $109.55 in May and $114.96 on Memorial day, up 73% year-over-year.?

In part, this reflects the reality that global energy demand recovered from the pandemic more rapidly than OPEC anticipated and OPEC was slow to raise production quotas.?However, some OPEC members are also struggling to meet their quotas due to conflicts and mismanagement.?In addition, Russia’s invasion of Ukraine and the resulting sanctions have significantly reduced Russia’s output.?Last year, Russia accounted for 10.8 million of the world’s daily output of 95.6 million barrels.?The U.S. energy information administration currently expects Russian output to sink to 9.2 million barrels by 2023.?

Today’s high crude oil prices should result in stronger production elsewhere in the world in the rest of 2022 and beyond.?However, for U.S. consumers, there is another problem.?

There are 42 gallons in a barrel of crude oil, so the May WTI price of $109.55 equates to $2.61 per gallon.?However, the average U.S. price of a gallon of gasoline in May was $4.55, or $1.94 more.?This spread, which reflects refiners’ margins, retail markups and taxes, was the highest on record and 41 cents higher than a year earlier.?This, in turn, reflects lower-than-normal gasoline inventories and very limited U.S. and global refinery capacity, a situation that has been exacerbated?by the war in Ukraine and resulting sanctions on Russia.

As in the case of crude oil production, very high refiner margins should, in time, increase supply and reduce demand.?However, there is no reason to believe that gasoline prices will fall quickly or sharply from here in the absence of a global recession.

Turning to food, today’s very high inflation reflects multiple issues but probably starts with the impact of pandemic assistance on consumer spending.?While the pandemic triggered a very sharp but brief recession, federal government fiscal aid has been very generous under both the Trump and Biden Administrations.?Three rounds of stimulus checks, in April 2020, December 2020 and March 2021, amounted to a total of $3,200 per adult, with further money for dependents, which obviously was more significant for lower income households.?Consumers also benefited from enhanced unemployment benefits, enhancements to the child tax credit and enhancements to earned income tax credits.?Partly as a result of this, real consumer spending on food jumped by 7.6% in 2020 and a further 3.2% in 2021.?This was an extraordinary surge in demand in an industry that has always run on tight margins and just-in-time inventories.?While real food spending has now fallen in five of the last six months, the shock to supply chains across food production and distribution has yet to fade.

Food production has also been impacted by a series of disasters.?A global avian flu has resulted in a surge in chicken, turkey and egg prices.??The Ukraine war has slowed the exports of Russian and Ukrainian grain and boosted the price of fertilizers.?And drought conditions and a labor shortage are contributing to an increase in U.S. fruit and vegetable prices.

As in the case of energy, very high food commodity prices should both tame demand and increase supplies and should, in time, bring food prices down.?However, for now, consumers are very aware of the outsized increase in food and energy prices.

That being said, whether higher food and energy prices are a crisis or an annoyance depends on your level of income.?In 2020, according the Census Bureau, the average American household devoted 15% of its disposable income to buying food and energy.?However, this varied from 42% amongst the lowest income quintile to less than 10% for the highest quintile.?Given that energy prices are now up 55% from 2020 levels and food prices are up 12%, even with fast-growing wages, the squeeze on low and middle-income households is very painful.?

This is likely reducing real spending on food and energy as well as other consumer basics such as clothing and household products.?In addition, it is contributing to a slide in consumer confidence, with the May reading of the University of Michigan Sentiment Index falling to its lowest level since 2011.

While lower consumer confidence may have only a minor impact in slowing consumer spending, it could contribute to business caution, perhaps reducing still very high job openings and slowing the growth in capital spending.?In addition, it increases the already high odds that November’s mid-term elections will result in a Republican takeover of Congress.?This would likely greatly reduce the chances of further fiscal stimulus between now and the 2024 elections.

Finally, while the Federal Reserve should have the insight to appreciate the drag effect of higher food and energy prices on the economy and the foresight to see that they will likely fade on their own, they may regard them as further evidence of the need for more aggressive monetary tightening.?

High food and energy prices do increase the risk of recession by hurting consumer spending, denting business confidence and potentially prodding the Federal Reserve into taking aggressive actions that they will likely regret later.?Indeed it is notable that five of the last seven recessions in the United States were preceded or accompanied by a period in which food and energy inflation exceeded overall inflation.

That being said, this is a peculiarly difficult time to make a recession prediction.?Unprecedented fiscal drag is being countered by unprecedented pent-up demand in an economy with unprecedented supply constraints.?To paraphrase Patrick Henry “we have but one lamp to guide us and that is the lamp of experience”.?That lamp is particularly unsuited to providing illumination in 2022.

For investors, however, the most obvious inference, is that food and energy inflation will either fade in the short run, setting the stage for a soft landing, or persist, and by doing so precipitate a recession that will bring prices down in a more brutal fashion.?Under either scenario, inflation is likely to be lower a year from now than today.?Consequently, in diversifying against many risks, investors would probably be wise not to attempt to bet on an increase in, or even a continuation of, today’s very high inflation.

For more of my insights, listen to my?Insights Now podcast?for a breakdown on big ideas, future trends and their investment implications.

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