Stagflation is the most probable scenario for the US economy, despite the fog of statistics emanating from the federal government.
Stocks in U.S. Show Negative Return on Inflation Gain
By Michael Tsang and Alexis Xydias
June 16 (Bloomberg) -- Inflation is eliminating the rewards of owning U.S. stocks. Surging commodity prices have eroded earnings and spurred the Federal Reserve to consider raising borrowing costs just as equities are trading at their most expensive in four years. Standard & Poor's 500 Index shares yield 0.22 percentage point more in profits than the interest on 10-year Treasury notes, the smallest advantage since 2004, data compiled by Bloomberg show. The last time corporate earnings returned less versus bonds, the index posted its first quarterly decline in more than a year.
The 39 percent advance in oil, 61 percent jump in corn and 41 percent climb in rice pushed the UBS Bloomberg Constant Maturity Commodity Index to a record this year. That's squeezing profits as raw-material costs outpace consumer prices by the largest margin since the 1970s. Companies in the S&P 500 will earn 7.7 percent less in the second quarter than a year ago, according to analysts' estimates compiled by Bloomberg.
``We now have an inflation scare that comes on the back of an already negative backdrop in earnings growth,'' said Florence Barjou, 35, a Paris-based manager at Societe Generale SA's Lyxor Asset Management SA, which oversees $100 billion. Her $1.2 billion Lyxor Diversified Fund dropped all of its bets this year on rising stocks, contributing to the fund's 19 percent return in the past year in dollars.
S&P's Decline
Today, the S&P 500 rose 0.11 point to 1,360.14. The S&P 500 has slid 7.4 percent since December, the biggest year-to-date decline since 2002. Almost $400 billion in losses tied to subprime assets and the collapse of Bear Stearns Cos. sent the gauge to its worst tumble in seven years in the first quarter. After rebounding in April, the index fell 4.7 percent on concern record fuel and food costs will force the Fed to lift interest rates even as the economy sputters. Yields on 10-year Treasuries jumped on June 13 to the highest level this year.
Rising bond rates make the payout from fixed-income investments more competitive with stocks. S&P 500 companies yielded 4.28 percent in reported profit versus their share prices last month, compared with 4.06 percent from 10-year Treasuries, data compiled by Bloomberg show. The last time the gap between the so-called earnings yield and government bonds was narrower was in May 2004. A quarter later, the S&P 500 lost 2.3 percent.
Profits are declining as U.S. companies' input costs rise faster than they can pass them on to consumers. At the end of March, producer prices including food and energy rose by 6.9 percent, compared with a 4 percent increase in consumer prices, according to quarterly data compiled by Bloomberg.
Pricing Power
The last time U.S. companies had so little pricing power was in 1975, after the Middle East oil embargo ushered in a decade of stagnant growth and price increases known as ``stagflation.'' 
While economists project that U.S. growth will grind to a halt in the second quarter, inflation accelerated to 4.2 percent last month from a year ago. That's more than double the rate in August, just before Fed Chairman Ben S. Bernanke initiated the most aggressive rate reduction since the 1980s, cutting the target rate for overnight bank loans by 3.25 points to 2 percent.
``The Fed is in a tough space,'' Byron Wien, chief investment strategist at Pequot Capital Management Inc., a $7 billion hedge fund based in Westport, Connecticut, said on Bloomberg television. ``They've got all the commodities working against them. Even though the economy is slowing, the price of oil and agricultural commodities is rising, so that's creating an inflationary pressure.'' The 75-year-old strategist predicted in January that U.S. stocks would drop this year as the economy falls into a recession and inflation rises.
Emerging Economies
Demand for raw materials in emerging economies and a weaker dollar underpinned the record-breaking 27 percent jump this year in the average price of 28 commodities tracked by UBS AG and Bloomberg. Inflation now exceeds targets in 80 percent of developed and emerging-market nations where central banks have them, Abhijit Chakrabortti, chief global equity strategist at Morgan Stanley in New York, wrote in a note last week.
In response, at least two dozen central banks from India and Brazil to Serbia and South Africa have raised rates in 2008.
``Central banks are now worrying about inflation more than about growth,'' Richard Cookson, London-based head of global asset allocation research at HSBC Holdings Plc, Europe's biggest bank by value, wrote in a report last week advising clients to cut their equity holdings. ``That doesn't mean we now like government bonds more. But it does mean we like equities less.''
Global Inflation
The fastest gains in consumer prices since at least 1992 have sent Vietnam's benchmark stock index to a 59 percent drop this year, the biggest among 88 global benchmarks tracked by Bloomberg. Chinese shares slumped 45 percent in 2008 as inflation climbed to the highest in 12 years in February.
In the U.S., valuations have climbed as earnings of S&P 500 companies fell faster than shares.
Ford Motor Co., the second-largest U.S. automaker, abandoned a target of returning to profit next year on May 22 because of rising costs for steel and gasoline. The Dearborn, Michigan-based company's shares dropped 20 percent in the past month.
Whole Foods Market Inc., the largest U.S. natural-foods grocer, slumped 19 percent since reporting on May 13 a bigger- than-expected drop in quarterly profit. The Austin, Texas-based retailer said sales growth slowed as shoppers reined in spending.
Jonathan Armitage, New York-based head of U.S. large-cap equities at Schroders Plc, which oversees about $259 billion, says the share declines created buying opportunities because inflation concerns are overstated. Slowing global growth will cool demand for energy and commodities, and a U.S. recovery will bolster earnings within 12 months, he said.
``Concern about inflation will dissipate, and that allows the equity market to look through what is obviously a challenging economic environment,'' said Armitage, 38, who bought retailers and railroads this year.
Stanford Group Suisse AG's Leo Schrutt is less sanguine.
``Stagflation is a very real and likely scenario in the U.S.,'' said Schrutt, 51, senior managing director at Stanford Group in Zurich, which has $60 billion under management for wealthy clients in Europe. ``What does this mean for stocks? I personally am waiting for things to get a little worse.''
To contact the reporters on this story: Michael Tsang in New York at mtsang1@bloomberg.net; Alexis Xydias in London at axydias@bloomberg.net.
