Time to Deflate the Deflation Expectations

  • Companies and consumers are counting on commodity deflation.
  • Where inflation pops up, companies will pass it along to consumers.
  • Trucking rates have been rising since February, and that’s inflation that hits the entire economy.

The Deflation Expectation

On recent earnings calls, restaurant chains were quick to declare that margins were safe thanks to a deflationary environment. For example, 40% of Denny’s (Nasdaq: DENN) non-labor costs are beef and eggs and the company has have locked in prices for the rest of the year slightly below last year. Denny’s, Jack in the Box (Nasdaq: JACK), El Pollo Loco (NASDAQ: LOCO) and many other restaurant chains guided for strong margins thanks to deflation.

Check out Cuddling and Egg McMuffins Show Economic Slowdown Underway

Commodity deflation is critical to offset rising minimum wage expenses. Beware the payroll hit when that deflation ends and margins get squeezed.

“Favorable commodity cost helped margins and we expect that to continue for the balance of the year. We now expect commodity deflation of approximately 2% to 3% at Jack in the Box versus our prior guidance of 2% deflation.” –Jack in the Box CFO Jack Rebel

“As a reminder, for the remainder of the year prices for all of our chicken needs are locked in and we continue to expect commodity deflation of 3.5% to 4% for the year.” –El Pollo Loco CFO Laurance Roberts

“We’re thinking now right now for the full year that commodity deflation, annual deflation will probably be somewhere between 2% and 3%.” –Denny’s CFO Mark Wolfinger

On the cost side, we continue to expect food cost inflation to be about flat in 2016… labor increases are being offset by the lower in the more benign commodity cost environment that we’re in. And that’s what we would expect to see continue for the rest of this year.” –Cheesecake Factory (Nasdaq: CAKE) CFO Douglas Benn

Trucking Rates Are Rising. The End of Deflation, the Rise of Inflation.

Trucking is the primary mechanism by which oil prices hit core CPI. In the US, over 70% of goods are shipped via truck. Everything consumers and business buy are immediately affected by changes to truck shipping prices.

There are two components: a shipping rate and a floating fuel surcharge (which is running ~10% of total shipping prices). In combination, rates are currently ~ per mile. Every penny added to shipping costs translates into a 0.5% rate hike.

Since February, fuel charges are up 2.5%. That gets tacked onto clothes, iPhones, tomatoes, etc. Everything just went up in price.

That’s a cold shower for the private sector where expectations continue to assume no inflation.

For a long time commodity deflation has masked services inflation, but now they are poised to contribute to inflation.

Put aside the CPI impact. The bigger issue is the impact on consumer sentiment and spending. Rising shipping costs will nibble away at households’ discretionary spending because, while small, it is pervasive. Companies are already passing along the rising costs to consumers.

Per the CFO from the Cheesecake Factory:

“[We have passed higher wage costs on to consumers by selectively raising prices in geographies where wages have risen.] It has gone smoothly. I was just in some of the restaurants in those markets recently and anecdotally have been asking some folks, and really it’s been accepted pretty widely.”

A Matter of Sequence

Inflation will start slow and then jump in six months. Consumers will face wage growth erosion, and that will affect the broader economy

By Q3, consumers will be back from vacation. They will see signs of inflation everywhere. Gas prices aren’t going down anymore and the impact on shipping costs will be established by then. Add in rising healthcare costs and animal spirits will be less positive. Just in time for the holiday shopping season.

By 1Q 2017, commodity price inflation will jump 3%-5% as companies lock in contracts at prices that reflect the higher oil price reality. In the case of food, higher oil prices will translate into higher fertilizer costs, higher feedstock costs, and so on.

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