Consumers May Be On The Hook

1/24/2011


Eventually, someone pays the bill.

Prices for crude materials — raw materials and supplies companies use to produce their goods — have been soaring. The crude-materials portion of the Producer Price Index has risen 65% over the last two years, versus a rise of just 9% for finished goods.

Businesses have aggressively cut operating costs, a common strategy in the wake of a recession. Despite the higher cost of inputs, the S&P 500 Index's operating profit margin has risen steadily over the last year, ending September 2010 at 14.6%, the highest level since the March 2008 quarter. But you can only squeeze expenses so far, and many businesses have been reluctant to raise their prices. With the cost of raw materials on the rise, something has got to give. Right now, it looks like the consumer could take the biggest hit.

In the 12 months ended November, U.S. wages rose 3.2% — about half of the average since 1959 — and just over 2% after inflation. As businesses attempt to keep their margins expanding, wage growth will probably remain subdued. Meanwhile, anecdotal evidence suggests that some prices at the wholesale and retail level have begun to rise. It's too early to predict the extent of those price hikes and their effect on end-market demand.

With companies determined to protect their profit margins, at least modest price hikes are likely this year, with increases eventually bubbling up to the consumer.

The combination of slow wage growth and persistent weakness in the labor and housing markets has kept pressure on consumers for more than a year. Spending on personal consumption rose an annualized 1.7% in the September quarter, well above levels common during the previous year but still about half of the long-run average of 3.4%.

The Blue Chip consensus projects consumer-spending growth of 3.1% in 2011, up from a 2.4% target just two months earlier. That projection requires an optimistic view of consumer demand.

Assuming the stock market reflects that optimism, if consumer spending falls short of expectations, companies directly dependent on the consumer face the most risk. Shrewd investors will keep an eye on quarterly profits and year-ahead guidance from companies in the consumer-discretionary sector.


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