There is a growing debate about why interest rates are rising. Is it inflation, expanding fiscal deficits, quantitative tightening, reduced foreign demand, lethargic monetary policy response, late-cycle fiscal stimulus, or a weakening dollar? After reviewing Q4 2017 operating results, it seems simple to me. The economy is expanding, labor markets are tight, and signs of inflation are building. In my opinion, rising interest rates are acting as they should at this stage of the economic cycle.
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In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
When I put on my Bottom-Up Economist hat, I’m viewing the economy through the eyes of business, not government data. While my macro views (especially on inflation and wages) have differed from government data for several months, recent CPI and PPI reports were more in-line with my observations. Furthermore, the latest job report confirmed the rising trend in wages I documented for most of 2017. Lastly, the government’s Q4 2017 GDP report showed an increase in inflation and an economy continuing to grow in a 2-3% range. In summary, my bottom-up macro opinion and government data appear to be converging.
Assuming government data continues to follow the path of my observations and conclusions, I expect to see future confirmation of a tight labor market and building inflationary pressure. In effect, I believe the reports on rising inflation and wages could be a start of a trend, not a one month anomaly.
While I continue to believe my opportunity set remains very expensive, the operating results for most of the business I follow and analyze was generally positive in Q4 2017. Barring a shock to the economy or sharp decline in asset prices (possibly one and the same), I’m not expecting a meaningful shift in economic activity in the near-term — business outlooks and backlogs are healthy, on average. That said, several variables that influence corporate profits are in transition, increasing profit margin uncertainty.
I have many questions as it relates to future corporate profits. Will volume growth and price increases be sufficient to offset higher costs, wages, and interest rates? Will a tight labor market help or hurt the economy (some companies noted labor constraints hurt operating results)? How will lower corporate taxes impact labor, demand, and inflation? Will positive business sentiment spill over into decision making? Will freight market constraints subside or intensify? How does a weakening dollar impact inflation and an already hot industrial/export market? Will efforts to lower inventory reduce promotions and increase consumer prices? When or will consumer businesses show a noticeable benefit from rising wages?
I’m looking forward to discovering the answers to these and many other questions. While patient investing can be unexciting at times, the shifting macro environment is making things much more interesting! I will be monitoring Q1 2018 operating results closely to learn more.
Below is a summary of several business trends I noticed during Q4 2017:
- Rising costs, especially wages, are becoming increasingly noticeable. Frequent discussions on strategy to pass on prices increases. In addition to labor, freight and commodity increases mentioned frequently. The shift from deflationary tone (2015-2016) to inflationary (2017-2018) is becoming more evident with costs and wages accelerating in Q4. Based on results and outlooks, this trend does not appear transitory.
- New tax law discussed frequently. There remains uncertainty, but overall the consensus is the law will be positive for most companies and the economy. Currently it’s more sentiment than actual data supporting optimism. We’ll need to learn more in Q1-Q2 2018. The tax benefit varies between companies and industries (depending on international exposure and expiring deductions). Most initial EPS estimate increases range from 10-20%. Capital allocation priorities remain unchanged, on average. However, some companies stated they plan on investing immediately in employees/wages.
- Consumer companies reported mixed operating results, with sales trends improving on average. It’s been over a year since I noticed the consumer slowdown (see post Elevated Consumer Discretionary Risk); therefore, it shouldn’t be surprising that year over year comparisons are easier and improving. Companies have had time to make adjustments, including large reductions in inventory and other costs. While the environment remains somewhat promotional, deep discounting is less widespread with more full-pricing noticeable (lower inventory strategies affecting). That said, there remains store closure pressure which initially hurts comps/increases promotions, but eventually helps. Lower inventories may also be responsible for recent uptick in inflation (last month’s large gain in apparel prices makes sense).
- Industrial operating environment is healthy. Growth is broad-based with construction and aerospace/defense reporting above average growth (mid to high-single digits). Material costs rising and pricing being passed on. Exports healthy, on average.
- Domestic energy industry showed further signs of improvement in Q4. Confidence in 2018 is growing with higher energy prices. E&Ps continue to appear to be more disciplined this cycle, with many attempting to drill within cash flow. Credit/capital, on average, remains available and relatively inexpensive. Most commentary suggest North America activity will be robust in 2018, while international has stabilized, with some predicting growth will return. The drag from the energy credit bust in 2015-2016 is officially over. The energy headwind has become a tailwind for many businesses.
- Auto manufacturing flat to slightly down. Little changes expected with estimates for small decline in auto production in 2018.
- Agriculture remains weak, but stabilizing.
- Rising freight costs mentioned on several calls. Transportation capacity utilization is high. Pricing and availability is becoming a greater issue. Difficulty in finding sufficient capacity and labor increasing. Barring a decline in economic activity, expect transportation costs to become a growing issue – was very noticeable this quarter. Companies are attempting to figure out how to pass on rising freight cost and maintaining sufficient transportation availability.
- Financials continue to do well on average. Bank loan and deposit growth healthy with low losses (as one would expect at this stage of the credit cycle). Insurance catastrophe losses increased in 2017. Premium pricing has firmed from declining to flat/increasing slightly. Despite increases in underwriting losses in 2017, there remains excess capital in the insurance industry. Interest income improving for banks and insurance.
- Technology results were mixed, but grew on average.
- Currency expected to shift from minimal variable to a noticeable tailwind in 2018. Several companies noted Q1 2018 should benefit from currency.
- Housing and construction is strong. Labor availability and cost remains an issue to meeting demand.
- International results were healthy. Asia strong. Brazil/Latin America stabilizing – more optimistic tone from several companies with sales in Latin America.
- Weather had mixed impact. Colder than normal (especially vs. last year) weather mentioned by some businesses, but did not influence quarter significantly.
- Supply reductions from China environmental efforts mentioned on several calls. Price increases could result for several raw materials.
Have a great weekend!
Article by Absolute Return Investing with Eric Cinnamond