Low Inflation Helps the Dow but Hurts Exxon and Chevron

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 Industrials (DJINDICES: ^DJI  ) is up 200 points as of 12:15 EDT. In most months, that move might well have reflected continued low inflation and its positive impact on the U.S. economy. But today's scheduled release of the Consumer Price Index didn't happen, as the Bureau of Labor Statistics is subject to the government shutdown. Nevertheless, using readings from other countries and more anecdotal evidence here in the U.S., we can draw our own conclusions about inflation -- and doing so points to favorable conditions for the Dow but potentially unfavorable ones for ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) .

Eurostat announced this morning that inflation in the Euro area fell to just 1.1% on an annual basis -- less than half its rate of a year ago. Prices have come down substantially in most of the indexes that Eurostat tracks, including core readings that exclude volatile food and energy prices. In particular, energy costs haven't been an issue, with year-over-year price declines of 0.9% comparing with a huge 9.1% annual rate this time last year.

In the U.S., we've seen the same impact. Figures from AAA show that retail gas prices are at their lowest levels of the year, having dropped $0.19 per gallon in September alone. Further decreases are expected, and prices in isolated areas have fallen below the $3-per-gallon mark.

Why inflation matters
Obviously, lower energy costs have a direct impact on revenue and profit for Exxon and Chevron. Exxon has struggled to keep its production levels up, and relatively high prices for oil and refined products have helped it offset sluggish production growth even as the company strives to find new sources of energy reserves to replace played-out wells. Chevron has had better success in growing its production, but doing so remains a constant battle for the oil giant, as it also faces the huge risks of environmental liability inherent in oil and gas production.

Chevron and Exxon have such difficulty in falling-price environments because what they sell is a commodity. By contrast, companies with substantial brand power prefer low inflation because it keeps their costs low while allowing them to continue commanding premium prices for their products. Nike, for instance, owes much of its long-term growth to its success in building a worldwide branding presence that drives consumer demand irrespective of its products' price tag. Coca-Cola has long reaped the rewards of commanding higher prices than generic cola sellers, and much of that owes to marketing that justifies wider profit margins over its costs.

Watch inflation now
Because so many Dow stocks lead their industries with noncommodity goods, the Dow generally prefers low inflation. But commodity stocks like Exxon and Chevron can go against the grain, forcing investors to consider both sides of the inflation debate in their portfolios.

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