TMFDeej (99.47)

Future corporate profit margins will be squeezed causing everything but ag and energy companies to suffer

May 16, 2008 – Comments (7)

Core inflation may remain tame in the near future as companies find it difficult to pass along price increases to consumers.  If this indeed happens, it is going to really hurt corporate profit margins, which as of the last quarter were sitting about 50% above their normal historical level.  Sure, increases in productivity account for some of this improvement but things like this usually eventually revert to the norm.  You know what corporations that are feeling pressure to improve their earnings are going to do?  At the very least they are not going to give their employees good raises that keep pace with the rate of inflation and in the worst case scenario they will lay people off, causing the unemployment rate to increase dramatically.

All of this is based upon the assumption that record food and oil prices are here to stay.  I feel extremely strongly that they are.  The U.S. dollar will continue to fall, causing the prices of these things to rise in dollar terms even if the supply and demand for them remain exactly the same as they are today.

Why do I think that the dollar will continue to fall?  Growth in Europe, Japan, and emerging markets is much stronger than it is in the U.S.  Take a look at the recent news on the subject:

- GDP revised lower to 0.6% in first quarter, Corporate profits growing at slowest pace in five years

- Robust German, French GDP growth underpins euro

- Japan's GDP Grows More-Than-Estimated 3.3% on Exports

As you can see, the EU and Japanese economies are in much better shape than ours (not to mention that the 0.6% U.S. GDP figure is misleadingly high).  Combine this with the EU's mandate to fight inflation which is much different than the Federal Reserve's current Keynesian policy of using monetary policy to stimulate growth and I don't see the U.S. raising interest rates at a faster pace than anyone else.  And this is just looking at rates, ignoring a whole host of other factors that will hurt the dollar like the current account deficit or massive Federal debt.

Weakness in our currency will cause the prices of things to remain high in dollar terms, but this is much more than a weak dollar story.  It is about supply and demand.  The people off emerging markets are demanding more and better quality food than they have in the past.  This is occurring at the same time the U.S. government is wasting food to use as an inefficient energy source.  Currently 31% of the U.S. supply of corn is being diverted away from people's and animal's mouths to create ethanol.  By 2009 / 2010 that percentage is scheduled to increase to 40%.  This massive waste of food is playing a big part in global food inflation.

Let's say that the U.S. government comes to its senses and modifies the current absurd ethanol policy.  That would cause prices to come down, right?  Yes...for a while.  Here is a great passage from the blog post by John Maudlin called Food for Tought that illustrates why any relief from an alteration in the ethanol policy might only be temporary:

"The total amount of arable land in the world is diminishing, primarily as a result of urbanisation. China alone has lost 3 million hectares of rice land to concrete in the past 10 years. In order to compensate for the reduced acreage, higher productivity levels are required. But higher yields require increased use of fertilisers which is not an option available to everyone given the price of oil. In some parts of the world, for example in Africa, there is now evidence of farmers planting less than in prior years as they cannot afford fertilisers. Falling yields are not a new phenomenon, though, as you can see from chart 3.

In one of the largest grain producing areas of the world - the former Soviet Union - the total acreage planted has dropped 12% since the iron curtain came down. The 3 largest producers in the area all suffer not only from reduced acreage but also from low yields compared to western standards. In Kazakhstan, grain yields are 1.1 tonnes per hectare, in Russia they are 1.8 and in the Ukraine 2.4. US grain yields, by comparison, are 6.4 tonnes per hectare4. The good news is that there is plenty of land available in places like Russia and Kazakhstan. The bad news? Experience suggests that it will take about 10 years to turn non-farm land into fertile farm land.

So that sums up my thoughts on why we're stuck with expensive food.  I had planned on going into why I believe high oil prices are here to stay as well but alas I'm running out of time.  I guess that I've already made my thoughts on high oil prices pretty clear in previous blog posts anyhow.

High prices for food and oil are here to stay, people, even if "core" inflation does not rise.  If we get any sort of drop in the price of oil and / or food investors would be wise to snatch up shares of any of the companies that will benefit from this trend.  Companies that are outside of these sectors may see their profit margins squeezed, hurting their earnings, and causing their stock prices to fall.

Man, I could write forever on this stuff, but that's all the time that I have for now.

TGIF.  Have a great weekend. 

Deej