<March 9, 2022>
Have you ever wondered if members of the Federal Reserve do their own grocery shopping? I know I have. Sometimes their actions conflict with what’s happening in the grocery aisles. For the past several months, the Federal Reserve has expanded its balance sheet even as food prices have soared. As the supply of money grows, the supply of goods and services has been strained, resulting in empty shelves, labor shortages, and higher prices.
I recently went on a BOGO expedition at our local grocery store, hunting for a deal on cereal. As I walked down the aisle, I noticed a man shaking his head as he stared at the cereal boxes. I immediately recognized the headshake as I recently had the same reaction after paying our homeowner’s insurance bill. It was the inflation headshake!
Since I knew why the man was shaking his head, I remarked, “Crazy, isn’t it?” He replied, “Yeah, I never thought I’d pay over $5 for a box of cereal.” I said, “And what’s even crazier is the Fed is still printing money.” Of course, that’s where I lost him and where I believe many consumers continue to be lost. Although Americans have caught on that inflation is a serious problem, many remain unaware of its source and the Federal Reserve’s role.
As inflation has persistently risen over the past several months, Fed members have talked a lot but have done very little. Like a forest fire, the Federal Reserve’s strategy seems to be to let inflation burn itself out, hoping it won’t jump the fire line. What the fire line may be remains uncertain, but we thought inflation jumping over 5% (eight months ago!) would have caused the Fed to act. But we were wrong—even after surpassing 5%, the inflation fire has been allowed to rage, feeding off trillions of newly created dollars and negative real interest rates.
While we acknowledge the year-over-year inflation rate may eventually moderate, we must ask, how much purchasing power will be lost by the time the inflation fire subsides? The U.S. dollar has already lost considerable purchasing power relative to most necessities, such as shelter. Over the past three years, the median price of homes sold in the U.S. has increased 30%. Even if shelter inflation moderates, past increases have made home ownership unaffordable for millions of Americans.
There is a lot riding on the much-anticipated decline in year-over-year inflation. Investors need lower inflation prints to justify abnormally low interest rates. And they need low interest rates to justify expensive equity valuations. In effect, moderating inflation provides investors with the cover to overpay and the Fed the cover to keep money easy.
To be clear, we are not predicting a decline in consumer prices. In fact, based on our bottom-up analysis of hundreds of small cap businesses, we continue to see an extremely tight labor market and a congested pipeline filled with additional price increases. Nevertheless, lower consumer prices are not necessary for the year-over-year inflation rate to decline. Instead, it may result from current prices being compared to elevated prices from a year ago. Easier inflation comparisons, or a year-ago CPI of 4% or higher, begin in April.
While investors wait for easier inflation comparisons, we believe they are missing another very important year-over-year metric that may be changing soon: consumer demand. Instead of being easy, consumer demand comparisons will become much more difficult over the next several months.
After leaving the grocery store, I stopped by a nearby gas station to fill up my tank. As I pumped gas and watched the amount owed exceed $80, it happened again—I caught myself doing the inflation headshake! I realized it now costs as much to fill up my tank as it does to buy a new pair of running shoes. And then I wondered how many people are making the difficult decision between filling up their tank and buying shoes? Since most people don’t walk to work, I’m assuming they fill up their tank!
Although most consumer companies have been able to pass on price increases without pushback, we believe there are limits and those limits may soon be approaching. This is especially true with businesses catering to lower income consumers. We’ve already noticed cracks forming with several consumer discretionary companies on our possible buy list, such as Big Lots (BIG), Hibbett Sports (HIBB), Rent-A-Center (RCII), and BJ’s Wholesale Club (BJ). In addition to inflation taking a bigger bite out of discretionary spending, the absence of COVID-related stimulus will also contribute to challenging comparisons.
Consumer discretionary companies that sell to shoppers with homes and stock portfolios, such as Target (TGT) and Costco (COST), have performed much better. However, these companies will also be facing their own set of difficult comparisons over the next several quarters. In addition to rising inflation and the absence of COVID related spending, we believe limited year-over-year equity gains will begin to weigh on the decision making of even the well-asset endowed. And given current valuations of some of the better performing consumer discretionary businesses (COST trades at 41x 2022 estimated earnings), we believe there is considerable downside assuming the demand boost from asset inflation fades.
After filling up my tank, I drove home to put away the groceries. On the way into the house, I checked the mail and noticed a letter from our neighborhood association. The letter explained that our association would be raising its fees “due to inflation and the significant increase in labor costs.” And there it was again—the inflation headshake! Later in the letter, the association explained it was delaying a repaving project as inflation was placing too much pressure on their operating budget. I took it as a clear sign that inflation is currently altering decision making and the timing of investments. In other words, demand destruction is already here.
We believe it is time for Federal Reserve members to visit their local stores and do their own shopping. Put down the spreadsheets and government data and go out and look around. Whether at the grocery store, home improvement center, or gas station, they’ll likely see frustrated consumers shaking their heads.
The long delay in addressing inflation is having real consequences. As policymakers drag their feet, a significant amount of purchasing power has already been lost and will likely not be coming back. Without the aid of additional stimulus and rising stock prices, we expect past and future inflation will take a more noticeable bite out of discretionary income and consumer spending in upcoming quarters.
As the risk of disappointing year-over-year consumer demand grows, we are becoming more interested in the consumer discretionary stocks on our possible buy list. We are hopeful opportunities may soon reappear as unchecked inflation and moderating asset inflation curb consumer spending. In fact, in several cases, valuations of consumer discretionary companies have already improved as their stocks have declined meaningfully from 2021 peaks.
As we watch for further declines, we shake our heads, knowing future opportunities will likely be a result of a Federal Reserve that dismissed inflation for far too long, refused to act, and maintained a policy of money printing and 0% rates, even as consumer prices surged.
Eric Cinnamond
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Definitions:
Whilshire 5000: The Wilshire 5000 is a market-capitalization-weighted index of the market value of all American-stocks actively traded in the United States.
BOGO: Buy one get one free promotion.
Consumer Price Index (CPI): The consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households.
Real interest rates: An interest rate that has been adjusted to remove the effects of inflation.
Discretionary income: Amount of money remaining after you pay essential bills such as your mortgage or rent, groceries, utilities and other necessary expenses.