Whistling Past Profit Graveyard

The PPI has troubling implications for margins, but stocks are rallying.
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A chilling conclusion could be drawn after the second key report on July's inflationary trends was released Wednesday: Amid soaring energy prices, the rise in consumer prices haven't kept pace with a steep increase in producer prices, which means that profit margins are going to get hit.

Yet as better-than-expected second-quarter earnings continue to trickle through -- the latest being from

Hewlett-Packard

(HPQ) - Get Report

after the close Tuesday -- major stock averages were solidly higher midday Wednesday. It also helped that crude oil was recently down $1.78 at $64.35 a barrel.

The Dow Jones Industrial Average

was recently up 0.7%, at 10,583.19. The

S&P 500

was up 0.5% at 1224.80. The

Nasdaq Composite

rose 0.7% to 2151.20.

The market's selloff on Tuesday -- when the Dow plunged 120 points and the other main averages all lost more than 1% -- was probably the more appropriate reaction, one foreshadowing future trends for the balance of the year.

Wal-Mart

(WMT) - Get Report

started the ball rolling Tuesday, after the world's largest retailer warned that its bottom line would be hit for the balance of the year as consumers were squeezed by soaring gasoline prices.

Tuesday also brought news that the consumer price index rose a larger-than-expected 0.5% in July due to higher energy prices. Generous sales incentives in the auto industry have kept down core consumer prices, which rose a smaller-than-expected 0.1% in the month.

But the consumer is only one side of the equation. Juxtaposing CPI with Wednesday's much larger-than-expected producer price index report, the result shows that firms are seeing their costs soar but have not passed them on to customers.

The PPI rose 1.0% in July, double what Wall Street economists were expecting on average. The rise was mostly due a 10.9% gain in gasoline prices. Excluding food and energy prices, the core PPI rose 0.4%, four times as much as economists expected.

Some gains in the core PPI came from rising light truck and car prices as automakers offered discount prices in June, instead of July as is customary. Over the two months, vehicle prices fell slightly on average.

But for businesses, who can't dismiss energy prices as inflation watchers do to come up with core readings, the bottom line is that input costs are rising.

With the PPI rising much more than the CPI, it means "profit margins are getting squeezed," says Wachovia senior economist Mark Vitner. "Most businesses are not able to pass along the costs of energy and of other raw materials to the consumer."

And it's not just energy costs that are rising. As revealed in the core PPI, price increases were seen in pharmaceuticals, aircraft, construction machinery, and floor coverings, notes Joel Naroff, president of Naroff Economic Advisors.

At the bottom of the production chain, the price of metals also rose -- including copper, iron ore, steel scrap, aluminum, and nonferrous metal ores.

What's worse, energy and metals prices have continued to rise since the July PPI study was conducted by the Labor Department, which doesn't bode well for August producer prices either.

In the meantime, businesses all the way up the production chain are feeling the pinch, according to Vitner, who's been conducting informal surveys with the likes of beer distributors and retailers. "Profit margins will remain squeezed for the second half of the year as firms continue to try to squeeze their costs

to keep prices down to accommodate consumers while energy prices continue to rise," he predicts.

"Many companies would like to pass higher costs along, but in most cases they just can't," he said. Consumers are also getting squeezed with the prices of gasoline rising."

The bond market, which rallied Tuesday after news that core consumer inflation remained tame in July, headed lower Wednesday after the stronger-than-expected PPI. Inflation erodes the value of fixed-income assets over time.

The benchmark 10-year Treasury bond was recently down 10/32 while its yield rose to 4.25%.

But that seems like the wrong conclusion. Sure, the

Federal Reserve

remains on track to keep raising short-term interest rates as long as employment and the economy keep rising at a strong pace. But inflation, for now, is not yet in the cards.

"Competition is keeping consumer prices from rising so inflation may not pick up much even with the wholesale price gains," Naroff says.

With productivity slowing, wage gains, and rising input costs, "it's earnings that are really the worry."

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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