After the Fed’s minutes were released yesterday a friend emailed, “I guess when rates [long bonds] are at 2-3% it’s difficult to admit inflation could be a problem.” I responded, “Let’s see…would the Fed rather have an inflation problem or the stock market decline 50%? Inflation problem hands down. I believe they’ll act accordingly.”
While you’ll never read about it in the Fed minutes, I suspect there is an ongoing discussion within the Federal Reserve regarding asset inflation and why it isn’t “properly” spilling over into the economy. Why has the economy been stuck in 1-2% growth with asset prices reaching record highs? Is Dow 20,000 not stimulative enough? What heights do asset prices need to reach to generate 3-4% nominal growth? Do we need Dow 50,000? $1 million 1800 sq/ft homes? What’s the magic number? And how can the Fed get to the magic number while it’s considering tightening monetary policy?
In my opinion, the Fed wants to raise rates, but is overly concerned about financial stability and an economy overly dependent on inflated asset prices. While this cycle’s asset inflation has been impressive, for the most part, it has only been sufficient to sustain last cycle’s excesses, not expand on them. Nonetheless, maintaining elevated asset prices remains an important policy tool as a bear market in risk assets would most likely send the economy into a recession.
The question isn’t if the Fed should raise rates, it’s can they raise rates while keeping asset prices inflated? That’s their challenge. Complicating matters further, it now appears the Fed has achieved its inflation target before the economy has reached “escape velocity”. It’s an interesting situation they’ve put themselves in. I’m looking forward to watching how this market, profit, and monetary cycle ends from the comfort of my patient positioning.
Enough talk about the Fed. It’s like thinking about what’s at the end of the universe – it will drive you nuts and it’s not very productive.
So what’s going on in the real economy? Fortunately several consumer companies reported operating results this week, providing us with some real-time data.
Wal-Mart’s (WMT) results made the news and caused the market and consumer stocks to rally. To be fair, what doesn’t cause stocks to rally these days? In any event, the market’s reaction increased my curiosity, so I checked it out.
Wal-Mart’s same-store comps increased 1.8% with a 1.4% increase in traffic. While not strong growth, I suppose in today’s retail environment positive traffic is a good sign. Adjusted earnings of $1.30 apparently beat estimates, but I failed to find last year’s EPS in their press release. However, I did find operating income, which declined 6.6%. Is Wal-Mart adopting the Amazon model of sacrificing profitability for sales? Growth is expected to be flat next year with earnings expectations of $4.20 to $4.40 versus $4.32. Same-store comps are also not expected to accelerate, with 1% to 1.5% comp growth expected next quarter. I don’t follow Wal-Mart closely, but their results and outlook don’t appear to signal much of a change in consumer behavior.
Home Depot (HD) was the other large retailer reporting this week. The company continues to perform better than most retailers considering its business is a major beneficiary of shelter inflation. Large ticket items continue to boost results with transactions over $900 increasing 11.6%. Total comps in the U.S. were up an impressive 6.3%. A little less impressive, but still respectable, was transaction growth of 2.8%. Average ticket increased 2.9%. Management noted average ticket “was slightly impacted by commodity price inflation and foreign currency.” The company is expecting same-store sales growth of 4.6% in 2017. Management’s sales guidance is based on a 2.3% GDP forecast.
An interesting data point from Home Depot’s conference call, “If you look at home equity, since 2011 home equity is up 108%. On average that equates to $50,000 per household. And we believe that is contributing, as people use the equity of their houses to spend back into their house we believe that’s contributing to our growth, so we factor that into our guidance, and that’s how we got to the 4.6%.” William Dudley (Fed member who recently discussed the wonders of home equity loans) should be happy!
Is management concerned about rising interest rates? Apparently not. “With a median home price in the country of $250,000, mortgage rates could go up to 7%-ish before the affordability index would fall at 100 or below. So there’s a way to go before we’d be concerned.”
Lumber Liquidators (LL) also reported results this week. Its stock soared 18% after the company announced same-store sales comps increased 2.8%. I was impressed until I discovered “traffic was down slightly” and average ticket increased 3%. Were investors celebrating operating results or inflation/mix? I don’t have a bone to pick with Lumber Liquidators, but an interesting comp/traffic data point nonetheless.
Texas Roadhouse (TXRH) saw its stock decline 12% yesterday after reporting slower than expected growth. The company reported same-store sales comps of 1.2% with traffic growth of 0.2%. Comps during the first 55 days of 2017 have increased 1.5%.
On costs, management noted, “…the impact of approximately 2.9% commodities deflation was offset by higher wage rate inflation and higher costs associated with payroll taxes, insurance reserve adjustments and gift card fees.” Similar to Ruth’s Chris, Texas Roadhouse benefited from lower beef costs. Labor costs are expected to remain an issue and management expects to address them with higher prices. Management noted, “We recently took some additional pricing in a few states where wage rates rose significantly.” The company expects mid-single digit labor inflation in 2017 (base wage rate up 4.5% in Q4).
Management commented on slowing trends stating, “I can tell you we would say we haven’t changed anything about the way we’re operating or doing business, so nothing that we could point to internally that would be changing those trends. I think there’s just a lot of noise right now between, like I said, between weather and some other stuff going on maybe on the macro side of things, just with the holiday shift and things like that. Outside of that, nothing that I can point to.” Management also commented on the industry saying, “Many of our competitors are struggling, for sure. We’ve seen a lot of tough sales reports announced recently from a lot of companies, and they have all taken certain amount of pricing actions relative to inflation, which especially on the labor side is getting tougher and tougher.”
And finally, I don’t follow America’s Car-Mart (CRMT) closely, but noticed their earnings release and found management’s comments regarding disappointing sales interesting. From their press release, “Our expectations were higher going into the quarter and some of the shortfall was most likely related to delays with income tax refunds this year. At the same time, we are certainly seeing some overall softness in the market after so many years of excess lending with significantly extended contract terms. Our customer base has been stuffed with offerings for several years now and we are feeling the negative effects of market conditions.”
“Our credit losses were elevated for the quarter, as for the most part we saw increased losses broadly across the Company. Even though we came into the quarter with higher delinquencies, we did expect better credit results for the quarter.”
Again, I don’t follow their business closely, but remain on alert for signs that the current auto cycle may be losing steam.
In conclusion, based on recent earnings results and company outlooks, it does not appear consumer trends have changed noticeably. I’ll continue to monitor results and adjust my views if necessary.