Category: Macro Analysis

How to invest when inflation picks up

I recently got back from an industry conference and my main takeaway was that 2018 could be the year of inflation. What does that mean and how should we position our portfolios?

To start, why do I think inflation will be ticking up this year? Anecdotally, I’ve heard from many employers from this conference that wages are up 20% year-over-year. That is significant! Recall, that wage growth has been one area stuck in low gear since the crisis, even as employment levels have recovered. As wages increase, firms costs increase and also increases consumers’ income to spend more, which helps inflation.

Turning to actual economics, demand-pull inflation occurs when aggregate demand grows fast than supply. When the economy is at near-full levels of employment, as we are now, that leads to increases in price levels. Why do I think demand will exceed supply? For one, consumer confidence averaged ~97 for all of 2017. That is the highest level since 2000, and according to University of Michigan’s economist, Richard Curtin, “only during the long expansions of the 1960’s and 1990’s was confidence significantly higher.” Plus, the stock market is up and setting new records, home prices are up, and while these do not cause inflation, it causes a positive wealth-effect that encourages the consumer to spend more and can buoy economic growth. In other words, these are indirect causes of demand-pull inflation.

I also tend to think cost-push inflation will also occur in 2018. Take oil and its derivatives for example. While not back above peaks, as we sit with it hovering around $60/barrel, that is well above the average levels of 2015 and 2016. Similar to wages, higher costs of other inputs rising leads to higher prices.

There are a few offsets to these inflationary forces, however. The fed is raising interest rates. Higher rates in the US should drive up the value of the dollar, all things being equal. Higher interest rates attract higher foreign investment, which causes the value of the currency to rise, in this case the dollar. This makes US good less competitive on a global scale. On the flip side however, higher inflation in the US relative to other countries will cause depreciation in the USD relative to those with lower inflation. Therefore, the impact of higher interest rates is mitigated by the fact that the US has higher interest rates than some countries, such as Japan or countries in the Eurozone which are combating deflation. The US also has a pretty bad current-account deficit (that is when a country spends more on foreign goods than domestically produced ones). We likely will continue to spend more on foreign trade than we earn, which will decrease the value of the dollar.

In addition, firms in the US will be able to fully expense capex for tax purposes, instead of the depreciation expense for tax deductions. Firms could invest in automation, crowding out labor and keeping wages down. In essence, we shouldn’t underestimate the deflationary impact technology can have. However, I tend to think this will take time.

But if I had to bet, I think inflation will tick up, which will cause interest rates to rise.

So where should I position my portfolio? Let’s start where I do not want to be. If interest rates finally due rise, the one place I do not want to be is low coupon, higher duration bonds and bond proxies (i.e. stocks that are highly correlated to bonds, like utilities and REITs).

I also do not want to be in stocks that have a long tail. For example, some biotech stocks valuations are through the roof based on the expectation in 3-5 years they will come out with a blockbuster drug. As the discount rate increases, these stocks will get crushed considering their earnings are further out. Tesla is another example of this…

On that note, we should consider that the discount rate for all stocks will be increasing. That could hurt the valuations of a lot of names as the S&P grinds higher (e.g. the S&P historically traded at 15x EPS, but now trades at 18x. Could there be a reversion to the mean?).

Where would I invest in these times? I am tilting my portfolio towards commodities. Although they have had a big run in 2017, we are still well below levels seen in 2011 and 2012 for commodities. If inflation ticks up, these have room to run and can serve as a hedge to my equity holdings. Refer to the chart below to see where we sit in the commodities world compared to recent history (chart depicted is the Bloomberg Commodities Index, which is made up of energy, grain, metals, etc.) Full disclosure, I own XLE, the energy ETF, MOO, the agribusiness ETF, and am considering BCX, Blackrock’s resources and commodities closed end fund, which trades at a ~7% discount to NAV and yields 6%.

BBG Commodities Index

Second, a tertiary bet on commodities is countries that benefit from rising commodities. I am also adding to my position with exposure to Brazil. Brazil is still coming out of one of the worst recessions it has seen in a long time in addition to a crack down on corruption. As commodities recover, labor improves and consumer confidence builds following the corruption scandals, Brazil could have a multi-year run ahead of it. I purchased both EWZ as well as BRF, which tilts to small cap, consumer stocks in Brazil as a leveraged bet.

Lastly, while I am avoiding REITs since I believe investors who have been starved for yield have driven up valuations, I do like the building products sector. Real estate tends to perform well in period of inflation, supply remains constrained, and we are still below average housing starts since the last recession. Even if interest rates rose 100-200bps, affordability is also at great levels. As such, I think building products is the sector to be in for the US.

US housing Starts

-DD

The question NOT being asked about Tax reform’s impact on stocks

A lot has been written about the Tax Plan passed at the tail end of 2017. I recently wrote a post on, while I think the plan is very beneficial to US equities, some considerations we should have on the rest of our portfolio.

And not to be a debbie downer, but I am here again to discuss some questions that are not being asked here. If you’re buying individual stocks today, I think the main underlying question for investing in that company comes down to one thing: Does this company have a strong competitive advantage?

In highly competitive industries, typically those that compete solely on price or sell commodities and have little differentiation, these tax benefits may soon be competed away.

Consider a distributor, which typically sells many goods and the only value it adds is perhaps customer service. Grainger has been an example of a distributor that has faced headwinds from price competition as customers look to Amazon for cheaper products. Take a look at GWW’s stock chart over 2017 to gain an understanding of this impact (stock was down 3-4% when the S&P was up 20%).

GWW’s stock really started to recover at the end of the year, one from earnings being better than feared on low expectations, but also due to its tax rate which should decline from 38%.

Given GWW’s heightened competition, due you think those savings will be used for buybacks or high return projects, or do you think they’ll be used to compete and maintain market share? Let’s say you think that’s fine if they use it to maintain share, as they’ll be in a better position. Well, do you think Amazon and other competitors won’t also respond?

Also consider the recent hikes in minimum wage from companies and $1,000 bonuses. They are doing that to attract and retain talent, which is simply another form of competition.

Hopefully you can see what I am getting at. Low competitive moat industries likely will compete the savings away. While the tax rate will be low, returns on capital may end up being the same.

-DD

Tax reform: Will it continue to boost stocks?

Merry Christmas and Happy New Year, folks. The Trump & GOP tax plan is in, and stocks couldn’t be happier about it. But should we take pause as this bull market rolls on?

Before I begin on that, let me first say that I think in the short-term this is GOOD for stocks. Obviously, the after tax earnings of US companies should go up, considering the drop in the tax rate from 35% to 21%. Plus there is the added benefit of expensing 100% of capex day 1, though the impact of this may need to be seen, since bonus depreciation scheme today allows for 50% of capex to be expensed. But is this benefit priced in? Is there any warranted skepticism?

My concern, not to be a bear, is how late this fiscal stimulus is coming into the economic recovery. Along with central bank stimulus, we needed something like this in the 2008-2011 time frame, not 10 years after a recession when employment is at near “full” levels. Moody’s has a good chart that contrasts these tax cuts with those in prior administrations. Bottom line: this stimulus, not even considering the $1 trillion infrastructure plan Trump has outlined, is coming very late in the cycle and when our debt to GDP is already at high levels.

Capture While its entirely possible stocks continue to march higher, just consider the possibility that this tax plan either boosts demand higher for goods, which means higher inflation and bonds go lower/ interest rates higher (think demand pull inflation from a boost to economy), or the market gets concerned about the deficit and treasuries go lower / interest rates higher. Frankly inflation has been stubbornly low for so long that it almost makes me think it has to happen (expect the unexpected…).

In either case, this means cost of capital goes up which could hurt valuations for stocks and in the worst case, wipe out any benefit from tax reform. Just something to consider going into 2018 as we review our portfolios.

-DD

 

Valuations are nuts… What’s a Value Investor to do?

As I research different companies across various sectors and review where they are trading, I can’t help but think: Wasn’t this company trading at 6-8x EBITDA 3 years ago and now its trading at 9-11x?! Its true. Much has been written about valuations expanding and as the WSJ reported in 2015, buyout multiples now exceed 10x on average — the highest level in 20 years! Is this justified? Are we heading for a crash? How should we position ourselves now?

The argument for “Keep Calm and Carry On”

One thing we need to remember is that these multiples are based on future expectations of cash flows and multiples are essentially short cut ways of expressing a DCF. NYU’s Stern school has a good presentation on the linkage should students want to dive in further. So one thing to consider now versus the past 20 years is that interest rates and therefore our discount rate are at all time lows. That in itself will raise the multiple as the net present value of future earnings are worth more when the rate is lower.

Secondly, low interest rates have made it increasingly difficult to find returns from normal avenues. Savings accounts used to yield 5% alone and now yield next to nothing. Now, a significant amount of junk bonds yield 5-7%. This has forced investors to go down the risk spectrum and buy a riskier asset for the same return, therefore pushing up multiples. “There is no alternative” or TINA has been coined for the phenomenon we are in today – “we can’t buy bonds and earn money, we must buy stocks”.

A third argument for multiples being this high is that earnings growth may be higher than what we’ve seen in the recent past, driven by tax reform, business deregulation, the US exiting the choppy growth phase following the great recession and this earnings growth will help pay for the high multiple we’re paying today. Or, growth going forward may actually be slower due to demographic changes (e.g. baby boomers aging) so each dollar of earnings will cost more…

The arguments “for” are endless… This happens in every cycle. If I could offer one thing to think about, read this snippet from an article in 2007 from Forbes, before the market crash. Does it sound familiar in any way, perhaps aside from housing?

“The world is awash in financial liquidity mainly due to appreciated house values, the negative U.S. corporate financing gap and the American balance of payments deficit. Inflation remains low despite higher energy prices. As a result, investment returns are low. Speculation remains rampant despite the 2000 to 2002 bear market. So, investors are accepting more risks to achieve expected returns. And then there’s the insatiable U.S. consumer, who, thanks to the booming housing market, continues to spend freely.”

Are these acceptable arguments? What’s an investor to do?

I don’t think so. Remember that history does not repeat itself, but can offer important lessons. I feel like our new short-term focused environment has led us to lose sight of the exact same things that happened just 10 years ago.

Remember that the Fed had intervened in the market significantly following the early 2000s recession and kept rates at historically low levels. This propped up one of the most significant bubbles in human history. Following that bust, the Fed again intervened and slammed rates down to the floor to help the economy recover. I fully believe this was a necessary action and showed we learned from the missteps that followed the great depression. However, we are now approaching 10 years since the previous market high and we are still in a scenario where rates are near nothing. Yes, inflation has been week, but I have to ask myself a chicken and the egg question here: are low rates supporting low inflation? I for one feel like I need to save more rather than spend since I know I earn less on investments. Companies have more dry powder to invest in new capacity. Supply can outstrip demand and drive prices lower. (Maybe I’ll touch on this more on that in a later post)

The point of this quick summary is for us to reflect on the Fed’s (and other central bank’s) unprecedented involvement in the markets. Despite political turmoil, high valuations, and plenty of uncertainty, the markets keep humming. This sort of complacency is exactly what led us into the last cycle. Ignoring things we know to be true, but fearful of missing out on the opportunity as the markets ride high.

Look no further than high yield (i.e. junk) bond spreads. The sort of complacency we are witnessing is hovering around the lows preceding the last crisis.

ScreenHunter 08

Whats a value investor to do?

What do we do? Do we sell everything?

Well, for one, we must remain diligent and core to our fundamentals. The market is an emotional beast and part of the emotion is not only buying correctly, but knowing when we should sit on the sidelines as well.

However, as much option value I enjoy from holding cash for the right opportunity, I can never advocate moving 100% to cash. JP Morgan put together a great chart of missing the best number of days in the market since 1997. If you somehow missed each of these days it would significantly hurt results! Calling the macro requires not only calling what event occurs, but how the market will react to it! I prefer to find mispriced securities in each environment, and when negative market reactions occur, either buy more or buy other assets that go on sale.

ScreenHunter 09

As Seth Klarman said, “Given the choice between holding mostly cash awaiting the periodic market tumble or finding compelling investments which earn good returns over time but fluctuate to a certain extent with the market amidst turbulence, we choose the latter. Obviously, we could not have earned the returns we have from investing, without investing.”

It is for this reason that I remain extremely selective right now. And to be honest, I am holding more cash. We can’t just buy something because we think that cash is burning a hole in our pocket. Sometimes cash and short term securities offer good option value compared to other investments.

Where should we invest?

The market has been so starved for profit growth, is it any wonder why the market is chasing companies that are reporting strong earnings growth? (Today that sector is tech). When everyone looks right, I want to look left and I think where we are in this cycle will favor value names or those names that are already at cyclical trough. And the best part of value investing is instead of having to accurately predict that Company XYZ’s earnings growth can not only stay strong, but also meet high guesstimates from Wall Street, we just have to wait for the gap between price paid and true value to narrow.

-DD