As anyone who has been to the gas pump lately can tell you, signs of inflation are beginning to stir. The latest signal came Wednesday when the Labor Department announced that core producer prices for December rose 0.5 percent, the biggest increase in more than two years.
Is inflation going to heat up? Most economists agree that the answer is yes. The really important question at least for investors is where the price increases are likely to occur, according to Vadim Zlatnikov, chief market strategist at AllianceBernstein.
Inflation will happen. I do think the risk of inflation will rise as we move throughout the year. But simply saying that the risk of inflation is rising is meaningless, Zlatnikov said in an interview. But if you know where inflation is likely to occur, you can own those assets and get paid.
Zlatnikov studied the pricing power of a broad range of industries during the fourth quarter in an effort to figure out where inflation will head next. He defined pricing power as the ability to raise prices relative to input costs, or the change in the variable gross margin. A few areas such as gold and bonds displayed great pricing power during the last year or two, and the gains have spread to other metals and agricultural commodities.
I think over the next two years, it will spread to other sectors such as autos, housing and retail, Zlotnikov said. Over the near-term the next two or three quarters Zlotnikov argues that pricing power will be limited to a handful of industries:
● The casino and lodging industries are able to raise prices, mostly because capacity is coming on line so slowly.
● Commercial aircraft manufacturers have shown signs of pricing strength as well, thanks to a backlog of orders.
● The specialty pharmaceuticals sector has been able to pass along higher costs, in sharp contrast to the major pharmaceutical companies, which are locked into highly competitive retail markets.
● Telecom services companies and cable TV operators are raising prices, although such gains are tempered by rising capital spending requirements throughout the sector.
● As the economic recovery has gained traction, restaurants have been cutting back on promotions and passing higher costs along to customers.
● Autoparts companies have had some success raising prices, although Zlotnikov notes that these expenditures are just a small part of total spending in the auto sector.
● And in the financial services sector, insurers who lost money during the financial crisis are making up lost ground by raising prices for variable annuities.
Overall, pricing power remains very limited at this time. Zlotnikov says that pricing power declined dramatically during the fourth quarter, despite an overall increase in sales. Most producers simply werent able to pass along the higher costs of materials and supplies, especially to middle income consumers, who remained budget conscious and willing to switch brands in search of the best price.
There are plenty of industries, such as mid-level home furnishings, food retailers, and offshore oil drillers that have no real ability to raise prices at all. Zlotnikov says he is increasingly concerned about the paucity of overall pricing power over the next few quarters. But even in such an environment, there will be a few sectors that will exert pricing power and create opportunities for investors.