At a time when economists are oscillating between hope for robust growth and fear of the threat of deflation, Morningstar is warning that the seeds of inflation, which it calls “the ultimate recovery killer,” are already sown.
Wednesday marked the final day of the first quarter of 2015, so the Chicago-based firm is one of many issuing analyses and forecasts.
And while, like many others, Morningstar offers its various numbers and projections, such as a GDP forecast of between 2 percent and 2.5 percent for 2015, the 9-page report stands out for its inflation alarm bell:
“We are trying to open investors’ eyes to the fact that even as falling oil prices have most economists worrying about deflation, the seeds for the next round of inflation are already in place, with broad implications for corporate profits,” writes Bob Johnson, the firm’s director of economic analysis.
What’s more, Johnson’s analysis offers cold comfort for inflation-phobes, since it might take an unexpected recession stemming from a geopolitical crisis or terrorist attack to “push out this day of reckoning.”
More benignly, wholesale societal changes like workers deciding, suddenly, to remain in the work force longer could also ward off inflation.
But barring these extreme outlier possibilities, Johnson sees many “seeds” from which inflation might suddenly and powerfully emerge.
The first source is labor scarcity born of long-term, and thus hard to reverse, demographic changes. U.S. population growth is on track to be 0.5 percent in the coming decades, from more than three times that level, 1.8 percent on average, in the 1950s, and 0.7 percent currently. Writes Johnson:
“Population growth, along with productivity changes, are the two key variables in determining economic growth. Therefore, economic growth over the next several decades will be restrained by the population growth reality. This is also a fact for most of the rest of the world, especially the developed world.”
That “reality,” as he calls it, is now upon us at a time when “U.S. born residents between ages 22 and 62 will decline for the first time in 2015 after adding well over a million workers per year at the turn of the century.”
Whereas inflation-adjusted wage growth was negative 0.3 percent just four years ago, it reached 1.2 percent in February — nearly twice its compound annual rate of the past 50 years of 0.7 percent.
Many industries — aviation and trucking, for example — have reported shortages of personnel, and Wal-Mart recently garnered national headlines in raising workers’ wages from the national minimum wage of $7.35 to $9 beginning in April, and to $10 over the next year.
While higher wages should have positive knock-on effects for consumer spending and consumer-oriented companies, Johnson expects overall profits to take a hit since labor costs have a high impact on corporate balance sheets.
Another “seed” of inflation is a narrowing “output gap” — the difference between the economy’s actual and potential performance. This slack in the economy has prevented sharp wage rises since the global crisis of 2008. At its widest point in 2009, the output gap was measured at over 7 percent.
But it has since narrowed to about 2 percent and is on track to hit zero by 2017.
“In the past, as the economy has approached full capacity, inflation has accelerated sharply,” Johnson warns.
Nor should investors take comfort in falling commodity prices, the Morningstar report continues. That is mainly because the lows they’ve reached — at least one popular index shows commodities to be plumbing 1990s levels — is suggestive of having reached a floor from which they are more likely to now head upward.
With wages rising and commodities looking ready to rise, investors should be on guard about corporate profit margins.
Not only are profit margins at 7.2 percent near all-time highs, but bears have warned that these high margins appear unsustainable for five years running already.
Johnson cites one analysis that foresees increased populist pressure on corporations to pay more taxes; that may put an end to current practices whereby corporations recognize income in low-tax countries.
So combine the Fed’s expected rate hike, higher taxes, increased labor costs (and concomitant need to invest more in capital budgets), together with a multiyear profit run the U.S. has not seen since the period between 1960 and 1965, and the jig may now be up for high corporate profits.
While investment analysts and economists continue to warn about deflation, Morningstar is not alone in worrying about inflation. Martin Feldstein, the chairman of the Council of Economic Advisers under President Reagan, sounded a similar alarm in Tuesday’s Wall Street Journal.
“Overall unemployment now is 5.5 percent,” Feldstein argues. “This has historically been regarded as about the lowest rate that can be sustained without starting an inflation spiral.”