<December 16, 2022>
It’s that time of the year again! It’s when we receive notice of our family’s largest expenditures, such as property taxes, tuition, and insurance. After reviewing the quarterly results of several property & casualty insurers, I was particularly curious about our homeowner’s insurance renewal. Based on industry trends, I was prepared for our premium to go up but wasn’t sure of the amount.
Just like Santa Claus, our homeowner’s insurance renewal came right on time! However, unlike Santa, inside the package (in this case an email) wasn’t a gift—it was an uncertain liability. I stood over my keyboard and rubbed my hands together, saying before opening, “Please, please, please, don’t be bad.”
I’ve never won the lottery, but whatever that feels like, after opening our homeowner’s insurance bill, I felt the exact opposite. It was a 70% increase from a year ago! While I was expecting an increase, I wasn’t expecting anywhere near that sort of jump. Given the increase amounted to what we budgeted for Christmas, I nicknamed the bill the insurance Scrooge!
While it’s natural to become agitated with the insurance company, I understood most underwriters are simply passing on their rising costs. Labor and material costs have increased significantly over the past few years, resulting in higher repair expenses and dwelling coverages. Litigation outlays are also on the rise, along with the cost of reinsurance. The insurance market is clearly hardening with additional premium increases likely.
The industry’s combined ratio (a combined ratio of 100 or higher indicates an underwriting loss) shows underwriting profits are near break-even. According to an article published by the Insurance Information Institute, the property & casualty industry’s combined ratio is estimated to be 100.7 in 2022. The article noted expected underwriting losses for 2022 through 2024 are a result of prior-year developments and inflation. Standard and Poor’s released a similar estimate, projecting a combined ratio of 100.4 in 2022, also pointing to rising inflation.
In its November 2nd statement, the Federal Reserve noted the Committee would take into account the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity and inflation. While taking its cumulative tightening into account sounds reasonable, we believe the Fed should take a more balanced approach, and also consider its cumulative loosening. By using its balance sheet as a guide, since QE began in 2008, the Fed’s cumulative loosening of monetary policy has been considerably greater than its tightening.
From our bottom-up perspective, we continue to watch the Fed's waves of money creation crash over the economy and businesses we follow. Similar to the insurance industry, companies in a variety of sectors remain committed to passing on rising costs that were incurred in prior periods. Further, as supplier and labor contracts are renewed, historical inflation data is often used as a guide, causing cost pressures to persist. And this is another reason why inflation is so challenging to contain once unleashed—the past is frequently used to determine the future.
As Wall Street celebrates its newly constructed consensus that the Fed’s tightening cycle will soon come to an end, many Americans continue to suffer from the Fed’s “inflation is transitory” blunder. From our perspective, investors’ obsession with peak inflation and the Fed pivot is one of the most fascinating aspects of current market psychology. Investors are so focused on where the rate of inflation is headed, they’re ignoring the significant amount of inflation that has already been created. This oversight is occurring even as it is becoming increasingly evident that cumulative inflation is weighing heavily on businesses and consumers. While certain costs have moderated, the inflation accumulated over the past several years is not retreating—it is sticking, continues to build, and most important, is clearly influencing decision-making.
Recent results from retailers highlight how the Fed’s cumulative loosening of monetary policy (not tightening) has been one of the main drivers of consumer behavior. Instead of subsiding, many retailers are reporting cumulative inflation, and the stress it has placed on consumers, has intensified.
Walmart (WMT) specifically discussed how cumulative inflation is affecting its business:
“Living with high prices through this year has a cumulative impact on our customers…regardless of income levels, families are more price-conscious now.”
Comments from Designer Brands (DBI) suggest consumer spending is constrained, and trends deteriorated as the quarter progressed:
“Macro pressures, including a constrained consumer and an excess of inventory in the industry, resulted in a drop in demand in the last 2 weeks of October. We expect similar dynamics to persist…”
Target (TGT) had similar comments related to the weakening consumer, persistent inflation, and how trends intensified later in the quarter:
“Even within the month of October, results in the back half of the month were much softer than in the first half…this rapid change in trend is consistent with what we're seeing in syndicated data on broader industry trends and the feedback we're hearing from our guests…consumers are feeling increasing levels of stress, driven by persistently high inflation, rapidly rising interest rates and an elevated sense of uncertainty about their economic prospects.”
Big Lots (BIG) discussed another recent theme of retailers—inflation is particularly harming discretionary spending:
“High inflation and the macro uncertainty is continuing to cause consumers to delay or cut back on discretionary purchases, especially of high-ticket items. Our customer is being pinched, and this pressure has been affecting discretionary purchases, especially for high-ticket items across the retail industry.”
Other retailers confirmed this trend, including Dollar General (DG)…
“We continue to see customer behaviors in Q3 that we believe indicate they are feeling increased financial pressure, including reductions in the number of items purchased per basket and in discretionary spending, which was softer than anticipated during the quarter.”
…and Kohl’s (KSS):
“Persistently high inflation continues to dampen consumer spending and our business, given our exposure to discretionary categories like apparel and home goods, which are facing disproportionate pressure. During the quarter, we saw our middle-income customers continue to purchase fewer items per trip and trade down to our value-oriented private brands.”
Another theme in retail is how inflation is contributing to same-store sales but negatively affecting transactions and traffic (possibly signaling stagflation). Home Depot was one example:
“During the third quarter, our comp average ticket increased 8.8% and comp transactions decreased 4.4%. The growth in our comp average ticket was driven primarily by inflation across our product categories as well as demand for new and innovative products.”
Brinker International also discussed:
"At the brand level, Chili's posted a comp store sales increase of 3.8%, driven by price of 7.4% and mix gains of 3%. An important part of the comp makeup this quarter was our concerted effort to move away from higher levels of discounting…this did contribute to the brand's negative traffic of 6.6% for the quarter."
Another emerging theme has been the noticeable increase in higher-end consumers shopping at discount stores. Walmart discussed in their last quarterly call:
“We've continued to gain grocery market share from households across income demographics, with nearly 3/4 of the share gain coming from those exceeding $100,000 in annual income.”
Dollar General had similar comments:
“Customers also continued to shift spending to more affordable options…while also shopping closer to payday at the first of the month…as well as seeing an increase in customers with annual household incomes up to $100,000.”
Several retailers noted they believe consumer savings may be drying up. Target mentioned this trend and noted inflation’s impact:
“With high rates of inflation contouring the road…many consumers this year have relied on borrowing or dipping into their savings to manage their weekly budgets. But for many consumers, those options are starting to run out.”
Big Lots also discussed consumer savings and inflation:
“The current environment continues to be challenging for our consumers. Inflation is at a 40-year high and consumer sentiment remains historically low. Household savings rates are below pre-pandemic levels as consumers have had to draw down on savings to fund current expenditures.”
As many retailers warn the challenging environment is expected to continue, Walmart noted persistent inflation was particularly to blame:
“The macro backdrop remains challenging as persistent inflation is impacting the consumer and our business.”
Target also confirmed weakening trends in its outlook and gave a glimpse into November:
“While already soft, sales trends in our discretionary categories softened even more in the last few weeks of the quarter, a trend that's persisted into the first few weeks of November.”
After opening our homeowner’s insurance bill, I called the insurance company. The representative was very nice and forthright. She said, “I’m not going to sugarcoat it, the increase is due to inflation and stuff.” Specifically, the cost to repair and build homes has increased meaningfully, which resulted in our higher premium. I explained that the Fed’s tightening policy works with a lag and asked when they expect our bill to decrease. She could not say. The best she could do was lower our dwelling coverage, which is equivalent to self-insuring, which I’m certain many homeowners have elected to do (knowingly or unknowingly).
Millions of Americans are getting similar bills this time of the year. Instead of celebrating the S&P 500 breaking above its 200-day moving average, they are making difficult decisions on what spending is necessary and what bills can be delayed, missed, or adjusted. In our opinion, elevated levels of cumulative inflation will continue to be a drag on consumer spending, consumer business operating results, and the all-important Christmas shopping season.
The Fed made an enormous error in miscalculating inflation and their ability to print trillions without consequence. As the Fed stirs investor enthusiasm by “taking into account the cumulative tightening of monetary policy”, cumulative inflation continues to build and influence real-world pricing and spending decisions. Without a sharp decline in the Fed’s balance sheet, asset prices, and economic activity, we do not expect cumulative inflation to recede to levels the stock market appears to be pricing in. Instead of focusing on the cumulative tightening of monetary policy, we suggest the Fed consider how its cumulative loosening over many years continues to pressure businesses to raise prices, suffocate the consumer, and threaten real economic growth.
Merry Christmas!
Eric Cinnamond
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Definitions:
Combined Ratio: The combined ratio is a measure of profitability used by an insurance. The combined ratio is calculated by taking the sum of incurred losses and expenses and then dividing them by the earned premium. A combined ratio over 100 indicates an underwriting loss and below 100 a profit.
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.
QE: Quantitative easing (QE): QE refers to monetary policies that expand, or increase, the Federal Reserve System (Fed) balance sheet.