by Brad M. Weafer, CFA | Chief Investment Officer
Executive Summary
- Inflation is top of mind and we are witnessing price increases in a wide variety of goods
- There is a compelling debate whether current inflation will prove temporary as a result of the pandemic or more long-lasting
- Investors should own equity in companies with pricing power and bonds with shorter-terms to best position portfolios for the future
It seems like everywhere you look today, prices are on the rise and the data supports this. Prices increased in April at the fastest rate in more than 12 years. The Core Consumer Price Index (prices excluding food and energy) rose 3.0% from a year earlier and 0.9% relative to March. The monthly gain in core inflation was the largest since 1981.
Even before the release of April’s figures, consumers had become increasingly concerned with inflation as evidenced by Google search trends (see Figure 1 below). Business managers are also focused on the issue. Mentions of inflation increased 800% year over year in first-quarter earnings calls of S&P 500 companies. It’s no surprise, as a broad number of products affecting all of us have witnessed significant increases. Lumber prices are up over 300% from last May, having doubled since March. This drives up the cost of home-building and remodeling projects. Almost all commodity prices from oil to steel have increased dramatically. The Bloomberg Commodity Index has gained over 50% relative to a year ago and 11% relative to a month ago. Price increases have affected a broad swatch of American life. Case in point, if you are ready to venture out for happy hour, chances are the cost of your buffalo wings is on the rise with wholesale chicken wing prices up 94% year over year according to data from the Department of Agriculture.
Figure 1
Investors Should Not Over-React to Recent Numbers
While the increase is notable, we do not believe investors should overreact. The unprecedented impact, response, and aftermath of the Covid-19 pandemic has an outsized influence on supply and demand. Production shutdowns last spring crimped the supply of goods across a wide range of industries. On top of Covid, severe weather impacted already-strained supply chains this winter. Demand for categories hit hard by the pandemic, like airfare and rental car prices, were severely depressed last year making price increases today look larger in comparison (called the base effect). The reopening is causing a surge in demand as people are willing and able to get out and spend. Policymakers themselves have played a role as well. Both the Federal Reserve and fiscal authorities have flooded the system with stimulus and prodded interest rates lower. These efforts helped maintain access to credit, provided a lifeline to those citizens whose employment was affected, and likely restricted the depth of the resulting recession. However, that stimulus enabled consumers to maintain income and savings levels has little precedent relative to past recession exits. As we advance through the reopening of the economy, we expect supply conditions to improve, demand to normalize, and stimulus to eventually decline or be withdrawn. Price increases should stabilize as a result.
Examples of How This Works
To illustrate the impact on a specific product, let’s examine the case of lumber. Many sawmills closed last spring in the depths of the shutdown in anticipation of a deep decline in demand. However, the opposite happened. People stuck in their homes, flush with stimulus money and unable to spend on services or travel, opted to invest in home improvement at unprecedented levels, essentially creating a run-on lumber inventory. Having initially been caught off-guard, the sawmills quickly reopened and increased production, but supply had not yet caught up to the unprecedented demand levels. Adding insult to injury, there has also been a shortage of available trucks to deliver materials, delaying what little inventory exists getting to market, and recent severe weather hampered production further. The end result is that lumber costs have skyrocketed. Are these changes permanent? As the old saying goes, “The solution to high prices is high prices”, which ultimately entices producers to add supply. Lumber itself is already showing signs of peaking as production has ramped to meet the demand. The impact is not instantaneous though and will impact certain products with varying timelines so the headline price increases may take some time to pass. Consider again our chicken wing example. In this case, the factors contributing to the shortage included closed chicken farms when there was lower demand from restaurants last spring, higher feed costs, and now a demand squeeze for inventory as restaurants begin to open capacity more widely. But as one industry economist put it bluntly, “If we have growing demand and a tighter supply, then prices go up, which is the market’s signal for, ‘Hey, let’s make some more chicken,’ but that takes time to get it done.”[1]
What Drives Inflation Long-Term?
Looking past the transitory impacts of the pandemic, what are the important factors to consider? The deflationary impact of innovation and slower population growth limiting overall economic demand are two of the primary drivers that have kept inflation in check for years. We do not expect these drivers to reverse course. The trend toward globalization has also been a limiting factor in the past but there is real debate if this trend is ending and may work in reverse in the future. The rapid increase in the money supply following the pandemic could also create inflationary pressure into the future. A greater supply of dollars acts as a headwind to the purchasing power of each dollar, effectively raising prices for domestic consumers. Most importantly, we see an expectation of higher unit labor costs. Many employers have communicated the difficulty in finding labor to fill vacant positions and the need to raise wages to fill occupancies. We see signs of this happening today. Consider just this week McDonald’s announced they will raise wages by an average of 10% for over 36,000 employees. Amazon announced they intend to hire 75,000 employees for entry-level positions in fulfillment and logistics at $17/hour with a $1,000 signing bonus. These are good signs for consumers and the economy, but also support higher prices throughout the economy.
What Does This Mean for Portfolios?
Whether price increases will prove ephemeral is the million-dollar question. Many investors have not had to weather long bouts of inflation in their portfolios. Those who have a longer memory fear the rapid inflation of the 1970s. Against this backdrop, we think it is important to be prepared for the specter of higher inflation while acknowledging we see good reasons why current price spikes will prove temporary.
For Fixed Income:
Higher inflation is a negative for fixed income allocations. In the simplest of terms, the fixed coupon you receive from a bond will have less purchasing power tomorrow when you receive the income as prices rise. Interest rates tend to rise as inflation expectations increase to compensate for that lower purchasing power. For existing bond holdings, prices move inversely to rates, i.e., as rates rise, fixed prices fall. The longer the term of the bond, the more sensitive its price is to changes in rates. This means a 10-year bond’s value will fall more than a 2-year bond with an equal change in interest rates. Market interest rates today do not compensate investors for the risk of inflation. To illustrate, consider the charts below (see Figure 2 below). U.S. inflation expectations are currently 2.7% over the next 5 years. A 5-year U.S. Treasury currently yields 0.84%. That means the real yield (yield adjusted for inflation) is negative. We believe investors should keep the average duration of their bond portfolios low to lessen any impact of potentially higher rates and increases in inflation expectations. While credit spreads are tight, we continue to suggest portfolios include investment-grade corporate bonds which offer a better return outlook than U.S. Treasuries.
Figure 2
For Stocks:
Inflation or not, over-time stocks follow profits. And the best portfolio hedge against inflation is owning stock in companies that possess pricing power. We own a large number of companies possessing this characteristic and spend a lot of time looking for more. Consider the case of Sherwin Williams. Sherwin Williams is a leading provider of interior and exterior paint, primarily serving the professional painter market. Pros have historically been insensitive to price changes, as the cost of paint accounts for just ~10-15% of professional paint jobs and is generally passed through to the end customer (i.e. the homeowner). The result is that Sherwin Williams’ will raise prices when its input costs (largely volatile oil-based products which tend to fluctuate over-time) go up. The beauty of Sherwin Williams’ business is that it does not give back these price increases when commodity costs eventually deflate. This is a long-term tailwind to margins and profitability. When commodity prices increased during the 2010 to 2012 period, Sherwin Williams raised prices six times in two years with no noticeable impacts on their volume of sales or profits. But, when commodity prices then declined over the ensuing three years, Sherwin Williams’ profit margins expanded significantly. Just recently, Sherwin Williams announced 3% to 4% price increase effective Feb. 1 and suggested they will likely need to take further pricing actions if raw material costs remain at elevated levels. This type of impact is already being exhibited in a host of our companies, including A.O. Smith (leading provider of water heaters), Lennox (heating and air conditioning), and Scotts Miracle-Gro (lawn and garden supplies). This pricing power characteristic is not unique to home-related companies. Several other holdings have already announced price increases from Becle (maker of Jose Cuervo) to Air Products (supplier of industrial gases). Providers of software that are critical to business operations like Microsoft routinely raise prices for customers. This will benefit our holding in Microsoft as well as other software providers like Constellation Software, Topicus, and the software businesses within Broadridge, Moodys, and Fair Isaac Corporation.
In addition to these overt price increases, many of our companies directly benefit from rising prices. Take Copart for example. Copart auctions salvage vehicles on behalf of insurance companies when drivers total their cars in an accident, keeping a percentage of the sales price for its role in the transaction. Average selling prices of vehicles on Copart’s auction marketplace are directly tied to used car prices. The index for used cars and trucks increased 10% in April, marking the largest one-month increase since the government began tracking used car sales in 1953. This will have a direct, positive impact on the revenue Copart recognizes. Visa and Mastercard provide another good example, as payment networks are paid a percentage of the transaction value. If the cost of goods or services transacted on their networks are increasing, this in turn raises Visa and Mastercard’s revenue on the transaction. We also own companies that have business models that buy products from a diverse group of manufacturers and sell to a fragmented group of end customers. These distributors pass along prices directly from the manufacturer to consumers, thus insulating their profitability. We own varied distributors including Watsco (air condition products), SiteOne Landscape Supply (landscaping products), and Fastenal (diverse industrial products).
Conclusion
Policymakers see the current bout of inflation today as transitory. We tend to agree, but in the event that we are wrong, we feel very comfortable that our portfolios are positioned well for the future. The competitive advantages and attractive business models of the companies we own put management in solid positions to deal with inflation and not sacrifice profit. Additionally, our bond portfolios are invested to lower the interest rate risk presented by inflation.
The team at Boston Financial Management is always available to answer your questions. Please do not hesitate to contact your Wealth Manager directly, or call our main line at 617-338-8108.
[1] https://www.kxan.com/news/business/where-have-all-the-chickens-gone-wing-shortage-causing-prices-to-rise/
Market Commentary Disclaimer:
This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.