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What P&G’s Pricing Decisions Tell Us About Inflation

Inflation has been the relentless economic theme of the last two years. Even with interest rates higher than before the pandemic, global supply chains no longer paralyzed by virus-related bottlenecks, and the World Health Organization declaring an end to the COVID-19 emergency, prices for goods and services in many parts of the world continue to climb.

As the world’s largest consumer-goods company, Procter & Gamble provides insight into what’s driving the pricing decisions at big brands.

In the first three months of 2023, P&G raised prices a whopping 10% year over year, following a series of large price hikes implemented throughout 2022:

Best known for brands such as Cascade, Gillette, Pampers, and Tide, P&G sells items typically found in the bathroom cabinet or under the kitchen sink. They aren’t the sort of hot items consumers blithely splurge on—but they are necessities. Despite P&G’s brands being among the most expensive in their categories, customers are loyal partly because the premium price and name recognition suggest they can expect consistent quality. Family and home care are areas “where the consumer doesn’t want to risk failure,” Andre Schulten, P&G’s chief financial officer, said during an April earnings call. “You don’t want to wash your clothes twice, and you certainly don’t want to deal with a diaper failure.”

With the latest round of price increases, P&G sold just 3% fewer items during the quarter (with the company’s decision to scale back operations in Russia responsible for one percentage point of this decline). This tells us that P&G may be losing some customers to sticker shock, but most are still coughing up the extra money. In fact, shoppers were entirely undeterred in the US, where the company’s sales volumes were up.

P&G is starting to see pushback in Europe, where the problem of stubbornly high inflation is worse due to the conflict in Ukraine and resulting energy crisis. P&G’s private-label rivals, which sell cheaper alternatives to brand-name goods, have been slow to raise prices in those markets as European consumers opt for the more affordable choice. This contrasts with the US, where consumers aren’t trading down and market share for private-label brands remains stable at about 16%, according to P&G. Rather than cut prices in Europe, though, P&G is spending on product and packaging enhancements as well as marketing to boost its brand prestige. For example, it’s promoting Ariel and Tide laundry detergents for use in cold water for consumers wanting to reduce their environmental impact or energy costs.

One reason P&G continues to raise prices for consumers is that the company is feeling the pinch of inflation, too. While higher prices benefited its gross profit margin last quarter by 470 basis points, much of that was offset by higher input expenses. Even as freight and transportation costs have come down, certain commodities and materials, such as ammonia and caustic soda, have gotten more expensive as P&G’s suppliers look to cover their own increased labor costs. Meanwhile, as the company reinvests in its brands to entice shoppers through means other than competitive prices, its operating margin widened by just 40 basis points, an improvement nonetheless.

Inflation isn’t in the rearview mirror, even if it is starting to ease. The companies with the greatest pricing power are taking advantage while they still can.

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Does the Equity Market Know Something the Fixed Income Market Doesn’t?

Despite recent volatility the bond market has yet to lose its composure over the multi-decade high in inflation. In the US, ten-year Treasury yields have risen, but only to levels they reached prior to the pandemic, and, while ten-year real yields have been a little perkier, they are still below zero. As a result, the longer-term inflation expectations baked into today’s bond prices remain bunched up around 2% despite headline inflation running at over three times that rate. Short-term yields anticipate a series of hikes in the federal funds rate, the central bank’s standard response to persistent inflation, but even forward curves expect short-term yields to top out at only around 2.5%, within spitting distance of where they peaked back in 2018 when inflation was slumbering at 2%.

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A Ground’s Eye View on Inflation and Its Persistence

The pandemic sowed the seeds of today’s inflation. That much is clear. Last year, fear and government-mandated lockdowns sparked a global recession. Businesses rushed to cut production ahead of an anticipated slowdown in consumption, or were hobbled by forced plant closings, anxious workers, or snarled logistics. But the sheer sweep of the income support in many developed countries meant that household incomes didn’t fall nearly as far as had been expected based on the rise in unemployment. Unable to spend on services like eating out and travel, consumers flush with cash turned to buying, or attempting to buy, big-ticket goods and better houses.

The outsized demand for durable goods has run headlong into the diminished supply. While the springboard for price increases may have been reduced supply, the strength and persistence of those increases, which are now feeding through to labor markets, are raising the specter that aggregate demand is outpacing even normalized aggregate supply. There is precious little that monetary policy can do to counter supply-led inflation, but—Omicron willing—it is likely to be temporary. But if inflation comes to be led by stubborn excess demand, then tight monetary policy is the orthodox response, and we can expect central banks to hit the economy over the head with a brick to prevent a sustained wage-price spiral. Demand-led inflation would have significant implications for asset prices.

Inflation is notoriously difficult to forecast; even some at the US Federal Reserve (Fed) concede that it has no working model for inflation.1 We could do no better and accordingly make no effort to forecast future inflation. What we can do is talk to the companies we own or follow and tease out the impact on their earnings from the rising input costs they’re experiencing; their changing bargaining power vis à vis their suppliers; whether they are able to pass on higher costs to their customers before stifling demand; and how all that is coloring their business outlook. The following represents what our research analysts have been able to glean from those conversations.

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Getting Real About Inflation … and Gold

As favorable vaccine news piles up, the winds of reflation are stirring. Early signs of an equity market style rotation in favor of cyclical value stocks, a weakening of the safe-haven US dollar, and a run-up in market-derived measures of inflation expectations all point to a resurgence of animal spirits despite a gloomy outlook for the economy. With our monetary maestros promising easy money into the distant future come what may, it is time to spare a thought for what the possible return of higher inflation might do to your portfolio. Inflation is viewed as the bane of fixed income investments, and rightfully so. But inflation can also wreak havoc on stocks. In theory, inflation should have no impact on equities provided companies are able to pass along higher input costs to their customers. In practice, equity valuations are highly sensitive to changes in the price level, tending to plummet when prices jump. No wonder investors are already casting about for inflation protection.

For a vociferous minority, the only bankable hedge for inflation is gold. For them, every spike in the gold price is reproof of government perfidy and foreshadows an inflationary surge. The evidence linking gold’s price and inflation, however, is curiously threadbare. If gold is an unreliable hedge against rising prices, what role, if any, should it play in a portfolio?