Will Inflation Ever Threaten the Dow Again?

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Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

The Dow Jones Industrial Average continues to press higher, building on its gains from yesterday on hopes that the government shutdown and budget impasse could soon end. Reports suggest that Congress might agree to a debt ceiling increase and the reopening of the government to foster constructive discussion among lawmakers and other officials about a longer-term solution. As of 12:25 p.m. EDT, the Dow is up 93 points, while the S&P 500 has posted similar gain of about 0.6%.

Good news on inflation
With investors looking past the current crisis, one key element that has helped the stock market for years has been the low levels of inflation in the economy. Although today's scheduled release of the Producer Price Index was delayed by the government shutdown, all signs point to a continued lack of price pressures at the wholesale and consumer levels. That has been crucial for consumers, who have seen wages remain relatively stagnant even during the economy's recovery and would find even modest levels of inflation difficult to handle.

For the most part, markets around the world have seen a lack of inflationary pressure. Throughout Europe, recessionary pressures have kept prices in check, with inflation rates of 1% to 2% expected for most of the major economies in the region. Even China has kept inflation under the 3% level, although other emerging-market nations like India and Brazil have struggled to keep control of price increases, as their inflation rates are in the mid- to upper-single-digit percentage range.

Inflation and the Dow
The blue-chip companies that make up the Dow tend to be industry leaders that have a fair amount of pricing power regardless of inflation levels. For instance, Nike was elected to the Dow in part for its marketing prowess, which enables it to promote shoes and apparel that command huge premiums to their production costs. As a result, even if the materials or labor needed to make those products see significant price increases, the costs represent such a small portion of Nike's revenue that it makes only a minimal difference to profit margins. Moreover, Nike has the ability to raise prices to pass on those costs to customers, who have demonstrated a willingness to pay up for their products.

It's important to realize, though, that a lack of inflation isn't always good for individual businesses. Ever-cheaper computers have vastly improved productivity throughout the economy, but they've posed huge threats to the companies that produce those computers. Dow component IBM dodged a bullet by realizing the threat that hardware price-deflation posed, diversifying away from computer equipment to incorporate higher-value services. IBM has benefited from the huge demand for IT consulting as customers aim to make the most of the equipment they purchase.

By contrast, Hewlett-Packard was ejected from the Dow in part because of the collapse of its once-core PC business. Only recently has it sought to turn itself around by following a similar path to IBM's, looking more at higher-margin opportunities rather than trying to make money in what has become a commodity business. It's too early to tell whether Hewlett-Packard will be successful, but it does represent an example of how low inflation can cut both ways.

Inflation might be down right now, but it's premature to call it dead. Keeping balance between economic growth and runaway price hikes is a difficult thing to manage, but so far, it looks like policymakers continue to be on the right track.

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The article Will Inflation Ever Threaten the Dow Again? originally appeared on Fool.com.

Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Nike. The Motley Fool owns shares of IBM and Nike. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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