Price crackers

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Wheelbarrows full of cash feature strongly in the nightmares of central bankers. But while inflation is on the rise, it remains moderate in the developed world. Should equity investors be worried?

Equities are regarded as a hedge against inflation over the long term -- in the US, dividends have generally grown faster than the rate of inflation since the 1950s. Yet periods of rising consumer price inflation are bad news for stock markets in the early 1970s, when inflation rose, from 5.0 to 16 per cent in the developed world, global share values dropped by two-thirds in real terms. That is an extreme example, but higher inflation hits valuations. UBS calculates that on the evidence of the past four decades each percentage point increase in the rate of inflation roughly corresponds with a 1.5 point fall in the European market's ratio of share prices to earnings (its p/e).

Rising input costs also eat into margins. In some industries, such as steelmaking, these can be passed, on to customers. But in aggregate, a squeeze on profits is likely. Producer price inflation in the eurozone is running at 6.0 per cent year-on-year, compared with CPI at 3.0 per cent. That gap -- at an eight-year high -- needs to be absorbed somewhere, and comes at a time when the profitability of European companies, as judged by returns on equity and margin, is also at a record high.

The key question, both at the policy, and the company level, is the direction for wages. Labour remains the dominant cost for most companies, accounting for about two-thirds of all corporate expenses. So far, rises in inflation are mostly attributable to food commodity prices, up about 40 per cent in the past year, and energy, up by 60 per cent. These rises are highly visible to consumers and tend to displace discretionary spending. But they have not translated into materially higher wage expectations, yet.

To believe that margins will not collapse as economic growth slows, investors must hope that the threat of unemployment is sufficient to keep the pay demands of the workforce in check.