AI - Artificial Inflation

Brit Ryle

Posted April 28, 2023

I want to tell you about the most important takeaway I’ve seen so far from the ongoing stream of Q1 earnings reports.

Microsoft (NASDAQ: MSFT) obviously had a great quarter. Helped by enthusiasm surrounding its ChatGPT investment, the stock rose from $220 to $275 during the quarter, and ended it with a $30 exclamation point after a blockbuster earnings report sent the stock over $300 a share.  

But that wasn’t the most important development…

Facebook parent Meta (NASDAQ: META) had an even better quarter. The stock ran from $124 to $209 during the January-March period. Then its Q1 report ramped the stock to $238. 

But again, that’s not the one that really caught my eye (though I told you the stock was good for a bounce back on January 4).

Regional bank First Republic (NYSE: FRC) quarter was definitely, um, interesting. Utterly crushed from the $120s to $12 during the Silicon Valley Bank fiasco, First Republic actually traded up to $16 right before its earnings report. I don’t really have an opinion as to why anyone was feeling good about what the quarterly would reveal – at least not one I can express in polite company. But the report was a disaster, showing that the bank lost over $100 billion in deposits and the stock got cut in half the next day and has continued lower. 

I know, there are plenty of “analysts” out there saying that First Republic is just the tip of the iceberg, that the entire banking system is at risk. But there are 4,844 insured banks in the U.S. I can pretty guarantee that they all haven’t taken the same ham-fisted approach to managing their interest rate risk that Silicon Valley and First Republic banks did…

Besides that, First Republic’s $100 billion in lost deposits wasn’t actually lost. It went to the JP Morgan’s and Bank of America’s of the world – all the big banks showed a nice jump in depositor money. 

No, the most interesting little tidbit I’ve gotten from the flood of Q1 earnings reports came from PepsiCo (NYSE: PEP), of all places…

Pepsi Benefits from AI

Pepsi’s Frito-lay division reported a 16% gain in revenue even though sales volume was flat from the year before. It would be interesting if I could tell you that the revenue gain came from some startling Artificial Intelligence application that boosted margins for Dorito’s.  

But there was another kind of AI at work – artificial inflation. 

And it wasn’t just the Frito-lay division that benefited from higher selling prices. The North American beverage segment grew revenue by 12%, even though sales volumes actually fell 2%. And the Quaker Foods segment showed 10% revenue growth while Quaker beverages were flat and Quaker convenient foods sales volumes fell 5%. 

The implication is pretty obvious. Pepsi has implemented price hikes of around 15% across the board, and those price hikes have had a minimal effect on sales volumes – a casualty rate that falls well within “acceptable” parameters.

Bloomberg shared the following nugget from the CEO, which I’m going to reprint in full: 

“…as we said earlier in February, we have mostly taken the pricing already this year that we needed to cover for our cost increases. And that is where we stand at this point. We’re seeing a deceleration of inflation, not a reduction of cost, but a deceleration of inflation. And we think that with the pricing that we’ve taken already in most of our business around the world, that should be sufficient. Obviously, there are some markets, highly inflationary markets around the world where we might have to take additional pricing… but the majority of our pricing is already done.”

It’s pretty obvious what’s going on here. For Pepsi, “inflation” simply means the price hikes they’ve made on the products they sell. So when the CEO says “deceleration of inflation,” he simply means that Pepsi won’t be hiking prices much anymore. And in fact, he says that outright – “…the majority of our pricing is already done.”

The funny thing about price hikes like these is that we consumers typically accept them on the understanding that since the company has higher costs, they pass some or all of those costs off on us. It’s like conventional wisdom. 

But the thing is – Pepsi actually saw its gross margins get better during the first quarter. Which tells us that regardless of how much its own costs rose, it raised selling prices a whole lot more…

Artificial Inflation indeed…

The Fed and Artificial Inflation

I’ve seen this with a few other consumer discretionary and staples companies. Proctor & Gamble (NYSE: PG) enjoyed a little tick higher in gross margins. Hershey (NYSE: ) saw its gross margins fall slightly, from 46.7% to 46.3%, but said the drop was “…more than offset [by] gains from price realization [hikes]…”

Coca-cola (NYSE: KO) was similar – small loss in margins, nice jump for earnings…

There are more, but you get the idea – inflation at the corporate level is not the same as it is for you and me. Artificial inflation is when companies use an inflationary environment as cover to jack up prices. 

So, if Pepsi can be believed, they’ve jacked prices about as much as they plan to. At least on an anecdotal level, this suggests food price inflation will be coming down. Of course, food prices won’t get cut – higher prices are permanent. 

So what does this mean for the Fed meeting next week? 

The consensus is that the Fed will deliver a .25 point hike. Opinions differ for what happens after that. More hikes? Or will the Fed pause after next week?

I expect Fed Chair Powell to hint at a pause in his Wednesday afternoon press conference.

That’s it for me this week. Have a great weekend and I’ll talk to you Monday.

Briton Ryle
Chief Investment Strategist
Pro Trader Today