Inflation Eases Despite Higher Food Prices, Will Market Rally Decelerate?

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Inflation was flat in December. On an annual basis it has eased to 1.7%, down from 1.8% a month earlier, according to the Bureau of Labor Statistics Report on consumer prices. Trips to the grocery store, however, weave a different story.

Food prices have continued to march higher, rising for three consecutive months. Some food retailers like Whole Foods Market (NASDAQ: WFM) are passing these price increases on to consumers while others like old-school food retailer Safeway (NYSE: SWY) must partly absorb them, hurting profits.

Falling prices are usually associated with falling demand amid a weakening economy.  Between September 2011 and May 2012, inflation tumbled from 3.9% to 1.7% before rebounding. Does this latest slide in inflation foretell a future recession or will the economy and markets continue to defy gravity?  Although it's surged recently, the S&P 500 Index (SNPINDEX: ^GSPC) fell 1% in Q4.

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The food and beverages index rose 0.2% during the month and 0.6% during the quarter. It could have been worse.  At each step downstream in the value chain, food producers and retailers on average were unable to pass on 100% of cost increases to their consumers.

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This inability to pass all cost increases to end consumers means tighter profit margins for all companies operating downstream in the value chain.  For grocery stores like Safeway, this means even sharper cuts to already razor-thin margins, while natural and organic food retailers like Whole Foods enjoy pricing power and growth. At Safeway, margins got even thinner over the last 3 years while Whole Foods has enjoyed margin expansion at both the top and bottom of the income statement.

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Whole Foods is able to pass a greater percentage of these costs on to the consumer because of the growing number of health-conscious shoppers. Prices received by producers and paid by consumers for non-food goods and services have declined at nearly every level of the value chain. Prices of durable and non-durable goods declined in Q4 while prices for raw materials and consumer services continue to rise.

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Since spending on services account for roughly 65% of total consumption in the US, stable to strong pricing for services is allowing the US to stay on the positive side of growth in my view. While the government will not release personal consumption numbers for December until Jan. 31, the preliminary nominal PCE spending data for October and November is consistent with the change in prices of durable and non-durable goods during Q4.

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Despite the subdued data from the end of last year, the stock market has brought in 2013 with a bang.  The S&P 500 is up nearly 4% just a few weeks into the New Year and it looks like it could move even higher.  One risk to this trend is the release of the initial GDP report for Q4 and the year on Jan. 30, a day before personal income and consumption numbers.

Barring any major revisions in the October and November consumption data I expect an initial estimate of annualized Q4 GDP growth of 1.6% with a range of 1.4% to 1.8%. Full year growth will be disappointingly similar in my opinion.  Although many have lowered their estimates recently, the market will most likely react negatively, at least at first. With the Federal Reserve pumping $80 billion-$85 billion a month into markets, the melt up in equities could continue.


Neither The Mays Report nor G C Mays has a position in any stocks mentioned. The Motley Fool recommends Whole Foods Market. The Motley Fool owns shares of Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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