This Too Shall Pass: The Micro Case for Transitory Inflation

US inflation continued to soar in May, with the Core Consumer Price Index (CPI) up 0.7% month over month and 3.8% year over year—its highest annual rate in more than 25 years. That worries investors, and understandably so. Even moderately higher inflation erodes the real value of investment returns and often leads to higher interest rates. But is higher inflation here to stay? We don’t think so.

We believe this jump in inflation is temporary. We expect price increases to decelerate as the year progresses and as pandemic-induced supply constraints ease, allowing supply to catch up to demand and taking the pressure off prices. That’s the case for transitory inflation as we’ve argued it from the macroeconomic perspective.

But to test our hypothesis, we drilled deep into the underlying data—company by company—to understand the microeconomic case. Would businesses tell us a different story?

Natural Language Processing: Harnessing the Power of Big Data

Building a micro case for inflation is akin to examining each grain of sand on a beach, then rolling up the data to create a picture of the shoreline. Processing such an enormous data set requires a big-data solution. In our case, we turned to natural language processing (NLP), which allows computers to make sense of the content of written documents.

We began with an NLP analysis of nearly 30,000 earnings-call transcripts for 3,200 publicly traded US companies. We flagged all management discussions of inflation, as well as drivers of inflation and how management teams were adapting. In addition, we analyzed the words and phrases surrounding inflation mentions for insights into likely margin effects. Here’s what we found.

First, mentions of inflation tripled in February 2021 compared with both January 2021 and February 2020 as cost pressures began to occupy a larger share of management attention. The industrial and consumer sectors stand out for having the most mentions of inflation. That’s not surprising, given the bigger impact of the shutdown on goods and services.

Second, for now, companies appear to be absorbing much of the run-up in costs, rather than passing costs through to buyers. We see this in the context around inflation mentions, which, in aggregate, leans toward a margin-neutral or margin-negative tone. In contrast, a margin-positive tone would suggest that cost inflation can be passed through to consumers as price inflation.

Third, management teams attribute a significant amount of inflation to disruptions in the labor markets and the supply chain (Display). In our view, these kinds of pressures will be temporary, as vaccinations progress, schools reopen and enhanced unemployment benefits expire in the next few months, leading workers to rejoin the labor force.

Natural Language Processing Shines Light on Inflation Drivers

 

Digging Deeper: Insights from Credit Analysts

Knowing what company management teams think is just the start. We also wanted to learn what our own bottom-up credit research can tell us about current and continuing price pressures. To that end, we pooled our analysts’ company-level estimates of input costs and capacity constraints to generate aggregate and industry-level insights into the inflation picture.

On balance, this exercise told us that, while cost pressures are material, they’re not likely to be permanent (Display). About two-thirds of US companies are facing at least some input cost pressure, with the remaining third experiencing a lot of pressure. But our analysts believe these pressures are mostly temporary, lasting only through the reopening phase in 2021.

Input Cost Pressure Is Real but Mostly Temporary

 

The sector-level views tell a more nuanced story. Some sectors—including airlines, autos, hotels and leisure, industrials, retail, supermarkets, and tech—are experiencing moderate to severe input cost pressures that are likely to persist into 2022 and beyond, after reopening is complete. These sectors were among those most hurt by shuttered factories and stores or by travel restrictions at the height of the pandemic.

Many of these companies have the ability to pass higher input costs along, to varying degrees. In other words, higher end prices in these sectors could be here to stay. But will the pace of rising prices continue to accelerate? To determine that, we examined two more variables: the speed with which depressed inventories can be rebuilt and the severity of capacity constraints.

The result? We found that businesses generally have enough spare capacity to prevent sustained upward price pressure once supply chains start to normalize, even with an extended timeframe for rebuilding inventories. The technology industry proved the sole exception. Fortunately, many tech companies are addressing the problem by planning to add capacity in the coming year.

In contrast to sectors where cost pressures could be sticky, some sectors experiencing intense cost pressures today may find they fade quickly. For example, basics, homebuilding, consumer products, and food and beverage have seen higher costs stemming mainly from underlying commodities. And the commodity futures market tells us these higher prices will be short-lived.

A Transitory Jump in Inflation: Micro Aligns with Macro

The bottom line? Some industries could see sustained price increases, but the overall outlook is rosier.

Our company-level analyses confirmed that US companies are seeing significant cost pressures, given the shock of the pandemic shutdown. But we found no compelling evidence that inflation will continue to rise in the post-pandemic period. Indeed, our in-depth and up-close dive into US businesses tells us that today’s higher inflation is likely to ebb with the tide.

Authors
Susan Hutman
Director—Investment Grade Corporate Credit Research
Robert Hopper
Director—High Yield and Emerging Market Corporate Credit Research
Eric Winograd
Senior Economist—Fixed Income

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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