It’s Affordability, Stupid

<June 4, 2025>

I was sitting at a traffic light last week and noticed the sign above. Very clever—and very true. It’s hard to believe that inflation has been running above the Federal Reserve’s 2% target for over four years. It feels like just yesterday when the Fed was assuring us that inflation was transitory and would go back into the bottle. Of course, it never did.

Considering inflation’s persistence and the significant amount of purchasing power lost, it’s no surprise the cost of living is such a hot topic. We’ve been writing about rising costs and accumulated inflation for the past several years (What About the Dufresnes?). While the inflation rate has subsided from its peak in 2022, prices remain elevated and continue to increase. In our view, accumulated inflation and the building affordability crisis are underappreciated threats to consumer confidence, the economy, and asset prices.

Affordability is one of the most frequent and important themes we encounter during our quarterly review of hundreds of small-cap companies. Businesses tied to housing have been the most vocal.   

A leading cement, gravel, and aggregate company, Martin Marietta Materials, noted in their last conference call, “With respect to residential activity, affordability challenges continue to act as a natural governor on single-family housing starts.”

Timber and lumber supplier PotlatchDeltic had similar comments, saying, “Overall macroeconomic conditions continue to constrain consumer confidence and challenge affordability, leading to low buyer urgency in both new and existing home sale markets.”

Homebuilders have been discussing affordability challenges for several quarters. D.R. Horton noted, “This year's spring selling season started slower than expected as potential homebuyers have been more cautious due to continued affordability constraints and declining consumer confidence.”

KB Home had similar comments, saying, “Consumers are continuing to cope with affordability concerns and uncertainties around macroeconomic and geopolitical events.”

And lastly, Lennar stated, “While demand for homes remains strong, actionable demand is limited by affordability and credit, which remained challenged by limited funds for down payments as well as income qualification for mortgages.”

In addition to shelter, consumers are struggling to pay for other necessities. Flowers Foods, a market leading producer and distributor of bread, said on its last conference call, “Consumers continue to struggle with headwinds from inflation…lower-income consumers are particularly pressured as inflation has forced them to spend a greater portion of their income on food, with resulting cutbacks in general merchandise.”

Flowers Foods also commented on the growing dispersion between high and lower-income consumers, with the higher-end paying up for premium bread, while more consumers are trading down to private label. Like other areas of the economy, the middle-end consumer continues to be squeezed. Flowers explains, “…the bread category remains bifurcated with relative strength in premium and private label products, while the middle-priced portion of the category is weak.”

The trend in “premiumization", or targeting wealthier consumers, continues to expand throughout corporate America.  Flowers explains, “If you look at what's going on in the category, there's definitely a premiumization versus a value play going on here. What's getting squeezed is the middle.” In effect, wheat flour and whole grains for the beneficiaries of asset inflation, and bleached white bread for those reliant on working wages!

Accumulated inflation is also placing considerable pressure on families. In fact, the cost of raising a family has gotten so expensive, many are putting it off or deciding to have fewer children. As the birthrate and families shrink, so does the number of products and services consumed.

Flowers Foods is responding by offering smaller bread loaves, saying, “…households are smaller. A lot of single individuals and families are starting later…having that smaller loaf that you can consume without half of it going stale is something that consumers want.”

Smaller product offerings, expanding premiumization, declining discretionary spending, and simply doing without are not sustainable trends for a growing economy. And they certainly aren’t trends that support current equity valuations.

From our bottom-up perspective, affordability trends are not improving. Most of the companies we follow continue to report rising costs that will likely be passed on to the consumer. Packaging Corp of America is experiencing what many businesses are reporting, saying, “…we continue to experience inflation across most of our cost structure.”  

The transportation company J.B. Hunt explained that while they’ve been trying to cut expenses to offset rising costs, “…the inflation that's coming alongside that, I can't think of a single cost item that is actually down...”   

Financial market and policy trends also support the continuation of rising costs and reduced affordability. The dollar is weakening, asset prices remain inflated, government spending is accelerating, and tariffs are only beginning to flow through the supply chain. Meanwhile, many on Wall Street—and even some Fed members—anticipate rate cuts later this year and into 2026. In effect, more asset inflation and more price increases resulting from the “premiumization” of the economy.

Asset inflation—or the wealth effect—has been a very popular policy tool over the past 15 years. Of course, this “good” inflation hasn’t been shared evenly, with half of the population prospering and the other half getting stuck with the bill. In aggregate, an economy built on asset inflation can look healthy, with positive GDP, tight credit spreads, high stock and home prices, and low unemployment. However, from the bottom-up, today’s asset-backed economy appears increasingly imbalanced as wealth inequity and affordability challenges expand.

For companies focusing on customers that have benefited from higher asset prices, business is great. For instance, Ralph Lauren just reported a fantastic quarter with revenue and earnings per share up 10% and 33%, respectively. Gross margins increased 260 basis points to an impressive 69%, aided by a 9% increase in average unit prices and a shift towards full-price offerings. The company expects to raise prices again in 2026. Management said, “When it comes to our core consumer, which as you know, are more elevated consumers, they have remained resilient.” As long as the stock market remains near record highs, we expect Ralph Lauren’s “elevated” customers will continue to spend! 

On the other side of the spectrum, those without inflated assets face a very different reality, with consumer financial strain on the rise. Dollar General explains, “Our customers continue to report that their financial situation has worsened over the last year as they have been negatively impacted by ongoing inflation. Many of our customers report that they only have enough money for basic essentials, with some noting that they have had to sacrifice even on the necessities.”

The customers of Ralph Lauren and Dollar General are responding very differently to the rising cost of living. The ability, or inability, to afford higher prices is clearly illustrated by comparing the stock prices of the two companies. It’s also a great summary of the U.S. economy! In this case, a picture really is worth a thousand words (the average length of our blog posts).

In our opinion, the affordability crisis was created by an extended period of elevated debt growth, fiscal deficits, and a Federal Reserve determined to keep the cycle going through rate cuts, debt monetization, and perpetual bull markets. In other words, too much easy money, too many asset bubbles and bailouts, and a government that hasn’t faced sufficient pressure to rein in unsustainable spending.

In such an environment, it’s not surprising investors are positioned so aggressively. It’s no longer just about beating the markets—it’s about supplementing incomes with capital gains to keep up with rising living expenses. Stock option and crypto currency trading has spiked. Despite bubble-like valuations, inflows into equity ETFs suggest retail investors are investing as aggressively as ever. Are these signs of rational capital allocators, or desperate attempts to join the asset-rich half of the population?

While macro data may point to an economy that appears resilient—with moderate nominal growth, low unemployment, and steady consumer spending—beneath the surface, an affordability crisis is building. Though it may spare those with inflated assets, it is marginalizing and demoralizing a vital portion of the U.S. population. It’s another unsustainable trend built on years of easy money and an overemphasis on financial stability (keeping asset prices inflated). Like stock valuations, corporate profit margins, and government debt, we believe today’s affordability trends are overstretched—and will inevitably break. 

Eric Cinnamond

eric@palmvalleycapital.com

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Definitions:

GDP: Gross Domestic Product (GDP) includes consumer spending, government spending, net exports, and total investments. It functions as a comprehensive scorecard of a country’s economic activity.

ETF: An exchange-traded fund (ETF) is an investment fund that holds multiple underlying assets and can be bought and sold on an exchange, much like an individual stock. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of stocks.

Credit spread: The difference between the yields of two bonds that mature at the same time but are rated at different credit qualities. Credit spreads are among the best indicators of the broader economy's health, not just the creditworthiness of individual companies. Spreads between corporate and government debt are often used to measure if financial conditions are loose. Tight spreads often indicate investor appetite for corporate bonds is strong.

Basis point: One one-hundredth of a percent, used especially in measuring bond yields and profit margins.

Earnings per share (EPS): A commonly used measure of a company's profitability. It indicates how much profit each outstanding share of common stock has earned.