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Would You Rather

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Last week I reviewed the investment options in my kids’ 529 plan. Slim pickings was the easy conclusion. Similar to many 401k plans, 529 plans are typically filled with index or index hugging funds, with few if any absolute return options. Instead of investing in a stock or bond fund with impressive historical returns, I decided on the lowest return option – cash equivalents.

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In addition to limited investment alternatives, low interest rates and high equity valuations make contributing to a 529 plan today unappealing to me. In my opinion, it’s a good example of how low interest rates and inadequate future returns can discourage saving.

I was fortunate to grow up during a period of high interest rates. I was also fortunate to have a grandfather who understood the power of compounding. When I was born, my grandfather bought high-yielding CDs and set them aside for my education. Thanks to his sacrifice, along with Paul Volcker’s prudent and persistent monetary policies, the CDs compounded nicely and eventually funded a large portion of my college education.

I attended Stetson University in Deland, Florida. My grandfather didn’t call it college, but jokingly referred to it as “fun in the sun”. While I studied and made good grades, he was right, I was also having fun. I thoroughly enjoyed college. The independence, hanging out with friends, and even learning – it was as good if not better than the brochure advertised.

In addition to learning and having fun, my friends and I participated in spirited intellectual discussion and debate. One of my favorite debate forums took place while playing the game Would You Rather. Topics varied considerably and included important questions such as, “For $10 million, would you rather have a giant beach ball or bowling ball permanently attached to your left hand?” Or my personal favorite, “If required to do so, would you rather have ‘Hot Shots’ or ‘Say It Aint So’ tattooed on your forehead?” That was a tough one!

I was reminded of the game Would You Rather last week as I was catching up on quarterly reports and conference calls. As readers may recall, last quarter I noted and documented several examples of companies reporting rising costs and pricing power. Early indications suggest this trend is continuing in the third quarter.

While several companies I follow are reporting higher costs, government inflation and wage data remains subdued. As the dispersion between rising costs and reported inflation becomes more apparent to me, I can’t help but ask, “Would you rather rely on economic data gathered from operating businesses or government agencies?”

Of course, most economists and policy makers rely on government data to form their macro opinions. As such, it’s not surprising many central bankers are currently more concerned about inflation being too low than they are about inflation accelerating. In fact, on Monday, Charles Evans of the Chicago Federal Reserve said he was nervous low inflation might be structural, not temporary.

After reading Mr. Evans’ comments, I immediately thought of a cure for his low inflation anxiety. Specifically, I suggest he start a business and attempt to hire 100 qualified and skilled employees, such as welders, truck drivers, nurses, installers, painters, electricians, machinists, and construction workers. And try offering these skilled workers and potential employees an industry wage to join your company. Good luck!

In addition to rising labor costs, there were other examples of rising costs in recent quarterly reports and conference calls. Kroger (KR) recently made a very interesting comment on food inflation. Management noted, “…we had overall product cost inflation for the first time since 2015.” And, “Cost inflation trends for the second quarter were consistent by department with grocery, liquor, produce and meat all positive for the quarter. Deli was deflationary and pharmacy continues to be inflationary.” Food was one of the few areas where I was noticing declining costs over the past several quarters. That trend appears to have reversed.

Casey’s General Stores (CASY) reported noticeable wage inflation in its recent quarter, stating, “…store level operating expenses for open stores…were up approximately 3.9% in the first quarter, which includes our decision back in December to keep our commitment to salary increases for our store managers, stemming from the proposed change by the Department of Labor to increase the minimum salary for exempt employees.”

Lowe’s (LOW) recently reported comp sales of 4.5% with 0.9% coming from higher transactions, while 3.6% from an increase in average ticket. Management noted “job and income gains should continue to drive disposable income growth, and favorable revolving credit usage continues to hover near the highest rates of the current economic expansion, supplementing the spending power generated by stronger incomes.” The company also expects home price appreciation, or asset inflation, to persist.

And finally, Target (TGT) announced early this week that it was raising its minimum wage to $11/hour next month and to $15/hour by 2020. Management believes the increase is necessary to help attract new employees and keep existing employees – another clear sign of wage inflation.

While I’m curious if upcoming inflation reports will eventually reflect the higher costs and pricing I’m noticing, my investment process does not rely on government data. Instead, I use the operating results of the hundreds of businesses I follow to form a bottom-up macro and profit cycle opinion.

As Q3 earnings season approaches, I plan to pay very close attention to information related to corporate costs and pricing. As several Fed members communicate their concerns regarding inadequate inflation, I believe costs and pricing power may actually be accelerating. If so, investors relying on historically low interest rates to justify current equity valuations may need to reconsider their inflation sources and assumptions. In fact, while it’s difficult to predict the exact catalyst that ends the current market cycle (and sometimes a catalyst isn’t needed), I would put an unexpected increase in inflation and interest rates near the top of my list.

Article by Absolute Return Investing with Eric Cinnamond

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