Our Outlook for the Market

Signs of inflation are unmistakable--and we don't think this is good news for the stock or bond market.

Many companies will struggle to pass along higher input prices, which means lower margins and/or substitution of alternative inputs.

We think "moaty" firms will weather any inflation better than companies without a competitive advantage.

Inflation has been a big theme in the headlines this year, and we're not surprised at the level of focus on this important topic. In fact, our analyst team covering the consumer discretionary and staples sectors has been highlighting inflation as a concern since last fall, and virtually every sector is touched by this risk. While core CPI growth has been muted, total CPI (including food and energy) increased at a 6% annualized rate in February (the latest data available). Even if this never translates into high core CPI growth, we don't think higher food and energy prices can be ignored, as they clearly have a meaningful impact on consumer spending.

In fact, rising energy prices are playing a significant role in global inflation. High energy prices act as a tax on production. At $100 a barrel, crude oil represents 4% of global GDP, a level that is historically associated with recessions. Higher energy prices hurt twice: First, higher fuel costs must be passed through to consumers or absorbed in profit margins; and second, consumers are forced to funnel a higher share of their paychecks toward fuel, leaving less cash available for other purchases. This crowding-out effect takes the heaviest toll on consumer discretionary purchases, and we'll likely see the impact on companies in the coming quarters.

We combed through the newsflow coming out of the 1,800 companies we cover for incremental data points on whether companies are facing higher prices and how these firms are dealing with inflation. If we wait until the impacts of higher prices show up in all the high-level data, we've probably waited too long, as it will already be incorporated into stock prices. We are seeing several signs of higher input costs impacting corporate margins, particularly among no-moat firms, with cotton prices a prime example.

Take Vera Bradley VRA, where management expects a 30% increase in cotton costs in 2011. For a company like this, where cotton is a meaningful percentage of total costs, a cost increase to this extent could literally wipe out more than half of the firm's net income. We have seen similar cotton price issues at Carter's CRI, among others. While price increases may be able to offset some of the impact, we don't think it will allow these firms to recoup the full impact of higher input costs--not to mention that those price increases would add to the inflation problem.