<May 23, 2019>
Asset bubbles are often accompanied by creative narratives or taglines. Some are descriptive and some are very clever, but most are simply another version of why “this time is different.” After ten years of relentless asset inflation, this cycle’s most important narrative and tagline finally occurred to me. Inspired by a recent Businessweek headline, I’m nominating “inflation is dead” as this cycle’s leading catch phrase to justify record high equity prices and extremely low bond yields.
The belief in inflation’s demise has played a critical role in elevating and sustaining asset prices over the past decade. In an inflationary environment, persistent and aggressive central bank stimulus would likely be considered ill-advised and counterproductive. In my opinion, without the “inflation is dead” narrative, quantitative easing, negative real interest rates, and the unlimited central bank bid would not be possible.
Based on my review of the financial media, the “inflation is dead” narrative appears to have gained momentum shortly after the Federal Reserve capitulated on its attempt to normalize monetary policy. From the standpoint of some in the media, the death of inflation is almost considered a fact these days. For instance, in the Bloomberg article “Did Capitalism Kill Inflation,” the author states, “With inflation dead or dormant, central banks are taking hits from the left and the right for not doing more to juice growth.”
Journalists aren’t alone in their view on inflation. Based on forward interest rates, market participants are currently pricing in a 31 basis point rate cut by the end of this year. In my opinion, investors wouldn’t be forecasting a cut in the fed funds rate (especially from such low levels) if they did not believe inflation was in decline or at least believe the Fed would operate according to that narrative.
As the “inflation is dead” narrative gains traction, we’ve been on the lookout for signs of deflation or disinflation within the operating results of the companies we follow. While there are some examples of inflation moderating in certain commodities – such as lumber, natural gas, and memory chips – there remains a considerable amount of evidence that suggests prices, on average, continue to rise.
Based on our review of Q1 2019 operating results and management commentary, we believe there is a growing disconnect between what businesses are reporting and the “inflation is dead” narrative. As the media, market pundits, and policy makers focus on inflation’s demise, businesses are continuing to openly report rising costs, wage pressure, and pricing power.
To illustrate the growing discrepancy between inflation appearing in corporate operating results while disappearing from the media’s narrative, we compared how many companies mentioned inflation during conference calls versus media articles each quarter. We thought the results were very interesting and confirm what we’ve been noticing. Specifically, while inflation is being mentioned less frequently by the media, it is an increasingly popular topic among businesses.
Why are companies discussing inflation more while the media is discussing it less? Could it be businesses and the media receive their data from different sources? Corporations receive information directly from their operating environment, while the media receives much of its data and guidance from Wall Street and the government (including policy makers).
Rather than relying on Wall Street or the government to help us shape our macroeconomic opinions, we prefer viewing the economy through the eyes of businesses. As bottom-up economists, we gather and aggregate a considerable amount of data and commentary directly from corporations to help us better understand where we are in the profit and economic cycle. We believe our bottom-up approach places us in an advantageous position to form an accurate, objective, and timely view of the economy.
Our current view on inflation is shaped by what is happening now and what may happen in the near future. When the incoming data from businesses changes, our macroeconomic views, including those on inflation, will also change. Until those changes occur, we’re not convinced and are not taking action on the increasingly popular narrative that “inflation is dead”.
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To help illustrate what many of the companies on our possible buy list continue to report, we’ve listed several examples of businesses reporting rising costs, pricing power, labor pressure, declining promotions, and other commentary that supports our belief that inflation’s obituary may have been written prematurely.
Rising corporate costs:
Oil-Dri (ODC) Q219 earnings call: “We've also incurred additional increased costs and those include fuel, freight, the manufacturing cost, packaging cost and customer compliance fees. While we anticipated the increased costs in both freight and packaging, we took pricing to the market in August of '18 to help compensate for these incremental costs. The actual costs in these categories had exceeded our estimates. As such, we are increasing price of cat litter effective May 1.”
Church & Dwight (CHD) Q119 earnings call: “Every single price increase that we talk about has to be cost justified in this environment. So it was cost justified...”
“Commodities are not abating right now, right. Commodities are up year-over-year. We said Q1 for ethylene, as an example, was a little bit favorable to what our outlook was. But that's it. In general, commodities are up significantly still from '19 to '18. So that's -- in this environment -- and oil, as you guys know, is back up to around $64, $65 a barrel. So that's not what the narrative is right now. Price increases are happening because of commodity inflation that's existing out there.”
Pricing power:
Hubbell (HUBB) Q119 earnings call: “And our pricing actions continue to gain traction. And we've turned the corner on price cost, which was a net positive for us in the quarter after being a headwind throughout all of 2018.”
Foot Locker (FL) Q418 earnings call: “Average selling prices were up double digits.”
Tempur Sealy International (TPX) Q119 earnings call: “…we're starting to see an increase in our average selling price for Tempur across our U.S. distribution channel.”
Regis Corporation (RGS) Q319 earnings call: “The company-owned same-store sales decline was driven by a 6.1% decline in year-over-year transactions, or what we have historically referred to as traffic, partially offset by a 3.6% increase in ticket.”
Declining promotions:
Dick’s Sporting Goods (DKS) Q418 earnings call: “Well, I think there were a couple of things that drove the ticket. So the AURs [average unit retail] were up. It was less promotional than it was last year.”
Church & Dwight (CHD) Q119 earnings call: “So as expected, all -- it seems all the manufacturers have pulled back quite a bit on promotions.”
Ralph Lauren (RL) Q419 earnings call: “Adjusted gross margin expanded 30 basis points in the fourth quarter and 50 basis points in constant currency, benefiting from reduced promotional activity and favorable product, geographic and channel mix.”
Acceptance of increasing prices:
Helen of Troy (HELE) Q419 earnings call: “We are encouraged by seeing other companies who have also been in the same position to take pricing.”
Hostess Brands (TWNK) Q119 earnings call: “Yes, so we have seen elasticity -- volume declines from elasticity, but it is in line with our expectations as the pricing has gone through. We've seen some retail price increases as our customers pass that through and it is in line.”
Central Garden & Pet (CENT) Q219 earnings call: “So with Garden, I'd say that the pricing was -- it went into effect January 1 and has been accepted obviously by all customers. And as George said, we'll have some surgical pricing in Q3 on some commodity-type items, but we're seeing the market move as well. So I don't think it's having a big impact on POS [point of sale] or takeaway because the entire market moved.”
Tight labor market and wage inflation:
Steelcase (SCS) Q419 earnings call: “…unemployment rates also fell and pay rates rose. We interpret this as evidence of a very tight job market with likely far more open positions than qualified applicants. This is the war for talent. We hear stories about this every day from our customers.”
SP Plus (SP) Q119 earnings call: “I think it's safe to say that we have seen upward wage movement. Minimum wages...seem to be heading towards $15 in most places over time.”
Texas Roadhouse (TXRH) Q119 earnings call: “So when -- we've been running the last few quarters, I think it is about 8% per store week up in labor and in some combination of wage inflation and other inflation in labor plus hours, and we do think that's going to continue. But we are going to have, for the first time in a long time, over 3% pricing.”
“You throw on top of that the Amazons of the world or anybody else, offering very high hourly wage rates or high from a historical perspective. There's a lot of…competition out there just fighting for good folks.”
Patriot Transportation (PATI) Q219 earnings call: “A shortage of qualified driver applicants and the related driver turnover continue to be a huge challenge for our industry.”
“After the close of the second quarter, management announced that we will close our Charlotte, North Carolina terminal. We have not been successful growing this business due to a very difficult driver market…”
Lightweighting:
Hostess Brands (TWNK) Q418 earnings call: “We, as you know, when we said last quarter, we implemented a multi-faceted pricing. So this pricing's part of it. We then adjusted some other components of it, including some weight-outs and other things.”
Transportation:
Dollar General (DG) Q419 earnings call: “While we have seen some signs of stabilization in a more balanced marketplace, we anticipate that we could see continued transportation cost increases in 2019.”
Tariffs:
HNI Corporation (HNI) Q418 earnings call: “For the full year 2019, we expect to grow profit while navigating several challenges, including a volatile demand environment, inflationary pressures and negative tariff impacts.”
General Parts Company (GPC) Q119 earnings call: “The pricing environment remained inflationary across our businesses in the first quarter with tariffs, price increases for raw materials, commodities and supplier freight each having an impact on our total costs. We continue to pass along our price increases to customers…”
Graco (GGG) Q119 earnings call: “…we're in a really good position when it comes to offsetting our cost pressures that we have from commodities and tariffs and other things with the pricing actions that we took. I would say that generally speaking, these are sticky.”
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In addition to debunking the current "inflation is dead" narrative, there were several other interesting developments and themes reported this earnings season. Unfortunately, our company highlights are much too long to include in this post (108 pages). If interested in learning more, please send us an email and we’ll be happy to send you a copy.
Past performance does not guarantee future results. Current performance of the Fund can be obtained by calling 904-747-2345.
There is no guarantee that a particular investment strategy will be successful. Opinions expressed are subject to change at any time, are not guaranteed, and should not be considered investment advice.
As of May 1, 2019, the Palm Valley Capital Fund did not own any of the securities mentioned in this commentary. Fund holdings are subject to change and are not recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk.
Definitions:
Federal Funds Rate: The interest rate that banks charge each other for lending money on an overnight basis.
Forward Interest Rates: Current expectations of future interest rates.
Basis point: One hundredth of a percentage point (0.01%).