<February 9, 2022>
My son and I have a dinnertime routine. As we finish eating, he looks at me, looks at his remaining vegetables, and asks, “Good enough?” I say no, and he reluctantly eats his vegetables as if he was being severely punished.
The recent routine between investors and the Federal Reserve isn’t too different. As the Fed begins to consider hiking rates and ending quantitative easing (QE), equity markets have declined. After each decline, investors look up at the Fed and ask, “Good enough?” To the market’s displeasure, the Fed has responded, “No, financial conditions need to tighten further.” In effect, rising interest rates and a shrinking Fed balance sheet are the broccoli and spinach of investing.
Of course, so far, the Fed hasn’t even served its vegetables. Its current offering of continued QE and 0% rates is akin to a full plate of jellybeans, cotton candy, and cupcakes! Nevertheless, just the talk of potentially serving vegetables caused many investors to throw a fit and sell stocks during the first few weeks of January. However, by the end of the month, the selling reversed as investors began questioning if recent declines were enough to cause policy makers to reconsider their plans.
And that appears to be the consensus. That as soon as the market declines “enough,” the Federal Reserve will reverse course by reinstating quantitative easing and maintaining negative real interest rates. In effect, despite paying near record high valuations for equities, investors expect to eventually be rewarded by another Fed pivot, or as we refer to it, the Fed panic.
In our opinion, investors expecting the Federal Reserve to pivot (panic) at the first sign of market stress are significantly underestimating inflation. Based on our bottom-up analysis of the companies we follow, inflationary trends are persisting and, in some cases, intensifying. Meanwhile, as investors and the Fed play their game of “Good enough?”, real world inflation is ripping family budgets apart, increasing inequality and political pressure for the Fed to respond. Every day the Fed sits on its hands is another day its credibility decays, along with much of the population’s savings and real income.
Based on our initial review of recent earnings reports and conference calls, we believe the Federal Reserve’s flexibility to backtrack on tightening will be limited by accelerating labor costs and strong corporate pricing power. Rising costs and pricing responses continue to be the main topic of discussion among business leaders. We’ve listed several examples.
Cracker Barrel Old Country Store (CBRL): Our labor costs were pressured by wage inflation on a constant mix basis of 9.1%, which increased throughout the first quarter and came in above our expectations, as well as elevated overtime use. Both commodity and wage inflation exceeded our expectations in the first quarter, and we now expect full-year commodity inflation and constant mix wage inflation in the high single digits.
Central Garden & Pet Company (CENT): Additionally, we will continue to face increasing inflationary costs in key commodities, labor and freight. And in response, we have developed a significant pricing and productivity agenda. Much of the pricing has already taken effect, while some is still to come as we progress further into fiscal '22.
Cal-Maine Foods (CALM): Our results reflect the current inflationary environment with higher costs for feed, labor, packaging and delivery.
UniFirst Corporation (UNF): Obviously, we continue to work with our customers on inflation and do what we can from a pricing perspective. But when you look at whether it's labor costs, whether it's the cost of outside products and merchandise and raw materials, there's just been a number of things that continue to be challenging that as we forecast out, we see as being incremental headwinds to our original forecast. But it really, I think, broadly, the message we probably give is that incrementally from a few months ago, some of those cost challenges are a little bit tougher.
Patriot Transportation Holding (PATI): This driver market is unlike anything I've ever seen. We'd love to have 75 more drivers spread out across our system. We haven't seen anything that indicates that we could add 75 drivers by this time next year. I mean…we're somewhere around half of the viable applicants that we had pre-COVID and we had a driver shortage pre-COVID.
Brown & Brown (BRO): For many industries, challenges continue to be the ability to find and retain employees, supply chain constraints and inflationary pressures. Ultimately, these factors are impacting how quickly companies can grow.
Healthcare Services Group (HCSG): Our fourth quarter results reflect continued margin pressures resulting from workforce availability, inflation and supply chain disruption. We remain actively engaged with our customers to modify our service agreements to adjust for the extraordinary inflation experienced during the second half of 2021, as well account for future inflation on a real-time basis.
J.B. Hunt Transport Services (JBHT): As I look across our business, the common denominator in terms of our pain points continues to be labor-related in wages, salaries, benefits and recruiting trends in both driver and non-driver. As has been stated in previous calls, the impacts of network congestion, labor shortages and general supply chain challenges are well known and have continued to have a meaningful impact on our business and are likely to persist, particularly given the heightened challenges evolving around COVID infections across our country.
Toll Brothers (TOL): On average, it is now taking us about 6 to 8 weeks longer to deliver a home than it took 1 year ago. We do not anticipate these labor and supply chain conditions will improve in the near term.
American Woodmark (AMWD): Our team continues to navigate a challenging labor, logistics and supply chain environment. Second quarter sales were up 1%, with demand continuing to outpace production across all platforms. The ability to match demand remains limited by 2 factors: labor and material availability.
United Natural Foods (UNFI): At least for the next several months, we don't see inflation easing. Many of the underlying drivers of this inflation, ranging from commodity shortages to labor shortages to limited transportation are also adversely impacting UNFI fill rates.
Tractor Supply Company (TSCO): As has been very well documented, the cost environment remains elevated across imports and domestic freight, commodities and labor wages. The fourth quarter comparable ticket growth included the benefit of approximately 850 basis points of inflation.
Darden Restaurants (DRI): For the second quarter, food and beverage expenses were 220 basis points higher, driven by elevated commodity inflation of 9% as well as investments in food quality, portion size and pricing significantly below inflation. Hourly wage inflation during the quarter was almost 9%.
The Sherwin-Williams Company (SHW): Our outlook also assumes that the market rate of inflation for our raw material basket will be up by a low double-digit to mid-teens percentage in 2022 compared to 2021. We expect to see year-over-year inflation in all 4 quarters, with the largest impact likely occurring in the first quarter and gradual reductions each quarter as the year progresses. We expect all commodity categories to be meaningfully elevated. We expect other costs, including wages and transportation, to be up in the mid to high single-digit range. We are currently implementing additional price increases in all businesses and will continue to do so as necessary.
The Scotts Miracle-Gro Company (SMG): The difficult decision to take a third price increase in a single year, while unprecedented for Scotts Miracle-Gro, was necessary in the face of continued cost increases that created a bigger headwind than we expected.
Oil-Dri Corporation of America (ODC): Pricing actions will apply to branded and private label cat litter items sold within the United States. The Company continues to experience substantial increases in freight, packaging, materials, natural gas, and non-fuel manufacturing costs, all of which are key components of its cat litter products.
In its effort to contain inflation, overstimulated demand, shortages, and an incredibly tight labor market, the Federal Reserve has relied on words over action. As a result, companies have been left to fight inflation on their own, implementing multiple price increases in 2021 and announcing additional increases in 2022.
With stocks down only slightly from their record highs, investors don’t appear overly concerned. The perception appears to be the fight against inflation will be brief and will soon reverse without penalty or sacrifice. And this, in our opinion, is the most crowded consensus view in the financial markets today. That after a shallow decline in asset prices, inflation will subside, the Fed will pivot, and investors will once again ride the Fed’s easy money wave to new market highs.
Based on the amount of inflation that has occurred and is in the pipeline, we believe the Federal Reserve has gotten inflation terribly wrong. For the Fed to regain credibility and achieve its price mandate, we believe a meaningful tightening in monetary policy or sharp decline in asset prices will be necessary. Although central bankers have certainly conditioned investors otherwise, whether they like it or not, we believe a large serving of vegetables is on the way. While most investors won’t like their taste, they are long overdue, healthy, and if positioned properly, can be delicious!
Eric Cinnamond
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Definitions:
S&P 500: The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
Basis point: One one-hundredth of a percent, often used in measuring yields.