Pella believes there is a material risk that elevated inflation will persist and force the Fed to implement more aggressive monetary tightening than many expect. This could have a profound impact on your portfolio.
According to Bloomberg, consensus expectations for US inflation is 5.0% in 2022 and 2.5% in 2023. Pella shares a similar view for 2022, however, we believe that inflation is poised to exceed 2.5% in 2023. Pella’s expectation is informed by four items:
“There has to be a mathematical reason for how bad that tie is” (A Beautiful Mind).
"You had my curiosity. But now you have my attention” (Django Unchained).
“You are without a doubt the worst pirate I’ve ever heard of (James Norrington)…. But you have heard of me (Jack Sparrow)” (Pirates of the Caribbean).
"Show me the money!” (Jerry McGuire).
“There has to be a mathematical reason for how bad that tie is”
The table below summarises key inputs for 4Q21 US inflation. According to the data housing inflation was 3.4%, which Pella considers peculiar given the median house price increased by 14% (according to NAR) in 4Q21 and average rents increased by 14% during 2021 (Redfin). There ‘has to be a mathematical reason for how bad’ the inflation calculation is!
| Weight | Price Change |
|---|---|---|
Durable goods | 14% | 9.7% |
Non-durable goods | 11% | 7.5% |
Total goods | 26% | 8.3% |
Housing | 17% | 3.4% |
Other services | 57% | 4.3% |
Total services | 74% | 4.1% |
Inflation (core-PCE) | 100% | 4.6% |
Applying a 14% housing inflation rate results in a 7% inflation rate, which is 2.5% higher than the reported rate. Pella concludes inflation is higher than what is being reported and/or will be driven higher as the timing issues relating to the housing calculation resolve.
“You had my curiosity. But now you have my attention”
Recent commodity price movements have caught our attention. Using the S&P GSCI commodity indices, over the past year industrial metal prices increased 100%, livestock prices almost 80%, agricultural commodity prices 84%, and crude oil 279%.
The chart below illustrates the annual change in core CPI and the S&P GSCI aggregate commodity price index with an eleven-month time lag. The chart indicates there is a reasonably strong relationship between commodity price changes and inflation eleven months later. This implies the recent material increases in commodity prices point to continued elevated inflation.
“You are without a doubt the worst pirate I’ve ever heard of (James Norrington)…. But you have heard of me (Jack Sparrow)”
Inflation has been the key topic during the most recent reporting season. The table below lists some of the company commentaries. These data-points point to an inflation rate that is well above consensus forecasts.
Company | Industry | Commentary |
|---|---|---|
Alcoa | Aluminum | The factors supporting higher aluminum prices represent fundamental structural changes that we believe will remain in place over the next decade. |
Allstate | Insurance | In 2021 increased prices 7.1% and these increases will show up progressively during 2022. |
Deere & Co | Farming equipment | Forecasting pricing increases of 8% to 10% in 2022, depending on the division. |
Ecolab | Specialty chemicals | “Our (Ecolab’s) pricing expectation for 2022 is expected to be in the 5% to 6% range” |
McDonalds | Restaurants | In the US in 2021, food and papers costs were up about 4% and McDonalds expects this rate to approximately double (to 8%) in 2022. |
PPG | Coatings | Increased aggregate prices by 8% in the final quarter of 2021and will implement additional price increases in the first quarter of 2022. |
Sealed Air Corp. | Plastic packaging | In the final quarter of 2021, increased prices by 12% and will increase prices a further 5% to 10% in 2022. |
Smurfit Kappa Group | Corrugated boxes | Box prices increased by approximately 19% y/y in the final quarter of 2021 and that increase gives some ‘impetus’ where pricing is likely to go in 2022. |
Sysco | Food distribution | In the US, food inflation was 14.6% and Sysco continues to see ‘elevated levels of inflation’ and might moderately decline in the back half of 2022. |
UPS | Logistics & package delivery | Increased pricing the US by 10% in 2021 and expects US industry pricing to remain firm in 2022. |
Waste Management | Waste collection | Working hard on its 2022 pricing plans to recover the inflation cost pressures and have “recently seen several large customers who have historically been very price sensitive renew at significant increases”. |
“Show me the money!”
Elevated and prolonged inflation coupled with the tightest labour market in generations is likely to result in higher wages. The first chart below compares growth in US employment costs since Mar-20 to the inflation rate. It demonstrates that since mid-2021 the US labour force has experienced a decline in real wages. The current tight market offers labour the opportunity to recoup some of that lost spending power through higher wages. This has already begun (second chart below) and will likely continue as labour negotiations take place, feeding into consumer prices and providing the impetus for ongoing elevated inflation.
Bringing it all together
Pella believes that there are several factors that point to inflation exceeding 2022 and 2023 consensus expectations, which is likely to result in the Fed tightening aggressively. Such a scenario will be a headwind to most (but not all) asset prices.
With this expectation in mind, Pella has some exposure to companies that will benefit from the implications of rising interest rates. Chief among these implications is volatility, which is a natural outcome of rising interest rates in a low interest rate environment, when bond duration (aka price sensitivity) is highest.
Where debt markets go, other asset markets follow. The implication being that one way to benefit from increasing interest rates is to invest in companies that benefit from asset price volatility. To this end Pella has invested in derivative exchanges (CME Group, Deutsche Börse), and a market maker (Flow Traders).
Pella also has exposure to companies that are likely to benefit from heightened inflation, including basic material companies. Given the nature of these companies’ exposures, it is critical that ESG/Sustainability issues are closely considered when investing in them. Examples of investments that have satisfied Pella’s economic and ESG requirements are Boliden (industrial metals), Antofagasta (copper), Weyerhaeuser (timber), and Vulcan Materials (aggregates).
Pella is confident that these stocks will provide our portfolio with some inflation protection in coming periods. However, we also believe that restrictive monetary policy is likely to be short-lived and the Fed will return to more accommodative monetary policy owing to structural issues facing the US economy. That is the subject we will explore in the sequel to this discussion.