Peace Deal or Not, the Inflationary Shockwave Is Already in the Pipeline
A cease-fire has been declared between the U.S., Iran and Israel…. But the damage has already been done from an inflationary perspective.
I’ve already delved into the inflationary impact that the Iran War will have on the data and real economy going forward. By quick way of review:
- The only data component of the Consumer Price Index (CPI) that has been in actual decline is Energy prices. In this context, CPI is losing its only deflationary impulse (all other components continue to rise albeit at a slower pace).
- While Energy only comprises 7%-8% of the CPI, spikes in energy prices have immediate downstream effects on the real economy: first transportation and logistics, then manufacturing, and then construction. It’s important to note that the pass-through effects of an energy spike worsen the further down the supply chain we go: the impact will be worse for construction than manufacturing and worse for manufacturing than trucking, etc.
Regarding that second point, we are already seeing signs that the financial system is discounting this.
The Dow Jones Trucking index has recovered well, suggesting this sector will be able to adjust rapidly to the spike in energy prices by implementing fuel surcharges or renegotiating contract rates via “force majeure” clauses due to the War in Iran. Put simply, the damage is done here and the sector is now adjusting based on this new reality.
However, the situation darkens rapidly as we move through the supply chain to the manufacturing sector. There, the damage from the spike in energy prices is much more pronounced as energy is a direct input cost for virtually every manufacturing process — natural gas for heat and industrial processes, electricity for machinery, diesel for internal logistics and receiving/shipping, etc.
Moreover, manufacturing operates on a pricing lag: most manufacturers sell on quarterly or annual contracts with fixed pricing. They’ve already committed to prices based on prior energy assumptions. So, when energy spikes mid-contract as they are now, these firms eat the difference.
And unlike trucking where a fuel surcharge can go into effect within a week, a manufacturer renegotiating a supply contract with a large OEM or retailer is a months-long process — if they can do it at all without losing the business. And unlike trucking, they cannot claim force majeure for most of this: force majeure pertains to business becoming impossible (as it is for trucking during an energy price spike) not unprofitable (as it is for manufacturing).
This is why the charts for large manufacturing firms like 3M (MMM) are struggling: the economics for the remainder of the year for the manufacturing industry have worsened dramatically. And unlike trucking, there is no easy or rapid fix.
Which brings us to what could easily be the sector of the economy that is hardest hit by an energy spike: construction. A manufacturer on a bad contract can slow production, reduce output, manage inventory. A general contractor on a fixed-bid construction contract has to keep building. The project is physically underway, the schedule is contractually binding, the owner has financing that expires, and stopping is often more expensive than finishing at a loss.
So, you get contractors who:
- Signed a fixed-price contract 12–18 months ago based on material cost assumptions that are now completely wrong
- Are legally obligated to complete the project
- Cannot invoke force majeure for the reasons we just discussed
- Are watching their margin evaporate week by week as they purchase materials at current prices
Residential construction feels the impact of an energy price spike fastest through lumber (energy-intensive to produce and ship), while also getting hit on the demand side — mortgage rates stay high if the Fed can’t cut because of inflation re-acceleration. In this scenario both supply and demand deteriorate simultaneously.
This is why the homebuilding index remains near its March lows despite the cease-fire agreement with Iran: the sector is realizing that the economics no longer work and won’t work for some time.
Put simply, the markets are indicating another round of inflation is coming shortly. The time to position for this is now before it hits.
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Best Regards
Graham Summers
Chief Market Strategist
Phoenix Capital Research