This quarter, Jon Manchester, CFA, CFP® (Senior Vice President, Chief Strategist - Wealth Management, and Portfolio Manager - Sustainable, Responsible and Impact Investing) tackles inflation, supply chain concerns, and the step up in regulatory maneuvers from China.
September 30, 2021
If any company should serve as the proverbial “canary in a coal mine” for inflation, Dollar Tree appears to be about the ideal candidate. With over 15,000 stores and a coast-to-coast logistics network, Dollar Tree has the requisite scale for purchasing power. However, unlike nearly every other Fortune 500 company, their business model effectively kneecaps their ability to pass rising costs along to consumers via higher prices. When the value proposition is largely predicated on selling items at $1 or less, that price ceiling puts a lot of pressure on the company to keep a lid on costs, no matter how many six packs of Moon Pie mini marshmallow sandwiches they hawk at a buck apiece.
Not surprisingly, Dollar Tree is acutely aware of this issue. In 2019, they satiated activist investor Starboard Value by agreeing to test out multi-price point offerings. Recently, Dollar Tree announced they will accelerate the rollout of stores offering $3 and $5 products and even floated the groundbreaking possibility of $1.25 and $1.50 price points. This latest backpedal from their dollar standard came after reporting a fiscal second quarter gross margin decline of 110 basis points(1) versus a year ago, primarily due to higher freight costs. Dollar Tree noted that spot market rates for ocean freight from China increased 20% just since May, and now expect its regular carriers will only fulfill 60% to 65% of their contractual commitments. The Dollar Tree business, they acknowledged, is “highly sensitive to freight costs.” It looks like the net result will be declining profits for Dollar Tree this year, despite higher revenues. This hasn’t escaped investors, who drove the stock down roughly 29% from its April 2021 peak level before a late September rally, spurred by the pricing moonwalk.
Rising costs are prevalent, with seemingly every company citing heightened supply chain challenges and steeper input prices. Retailer Bed Bath & Beyond, home of the 20% off coupon, expected a 240 basis point increase in freight costs last quarter, and instead experienced a larger 360 basis point jump. This helped to dent their adjusted gross margin by 190 basis points compared to a year earlier. Even relatively small margin changes can make a big difference on the bottom line. Bed Bath & Beyond said 100 basis points of margin variation impacts their earnings per share (EPS) by approximately $0.50, which is significant considering they previously projected EPS of around $1.48 for all of fiscal year 2021. Shareholders threw in the (bath) towel, sending the stock down 22% on earnings day.
Understandingly, Wall Street analysts tend to obsess over margins and the various levers at a company’s disposal to sustain or increase those margins. Companies, for their part, end up spending an inordinate amount of time outlining plans to achieve cost efficiencies and revenue synergies. In aggregate, this seems to be working. The Standard & Poor’s 500 Index established a record-high 14.4% operating margin last quarter. History would suggest a reversion ahead, closer to the 31+ year median operating margin of 12.3%. However, technology continues to play an outsized role in this story. The high-margin Information Technology sector now represents 27.6% of the S&P 500 Index versus 17.0% a decade ago, and that doesn’t include companies such as Amazon and Facebook that happen to be classified in other sectors. The other factor, of course, is the use of technology to operate more efficiently. As one example, market intelligence firm International Data Corporation (IDC) estimated in 2018 that organizations who migrated to Amazon Web Services (AWS) Cloud would save 31% on average in infrastructure costs. (2)
On a secular basis, technology can help minimize costs but, in the short-term, inflation is clearly here. The Federal Reserve’s (the “Fed’s”) preferred inflation gauge—the Personal Consumption Expenditures (PCE) Price Index—rose at a 4.3% rate in August 2021, its highest in 30 years. Eurozone inflation hit a 13-year high at 3.4% for September. The debate remains how long it will persist. Fed Chairman Jerome Powell admitted that “it’s frustrating to see the bottlenecks and supply chain problems not getting better – in fact at the margins apparently getting a little bit worse. We see that continuing into next year probably, and holding up inflation longer than we had thought.”(3) The Fed now projects 4.2% inflation in 2021, then cooling to 2.2% next year.
One key inflation metric is wage growth and, on that front, there is room for concern. The Labor Department reported a 4.3% increase in average hourly earnings for August 2021 compared to a year ago, up from a 4.0% rate the month prior. It’s difficult to dismiss rising wages as transitory. However, it’s expected that labor supply constraints should ease in the months ahead. Further, Goldman Sachs estimates that labor costs represent only ~13% of revenues for the median S&P 500 stock. (4) They note that—based on historical correlations—S&P 500 companies are relatively insulated from wage pressures, and their analysis suggests a 100 basis point acceleration in wage growth would translate to just a 1% reduction in S&P 500 EPS, all else equal. Smaller companies are generally more exposed to rising wages, according to Goldman Sachs, in large part because they have lower profit margins.
With inflation worries comes the potential for rising interest rates, and we did see the 10-year U.S. Treasury Note yield pop higher at the end of September. That said, its 1.49% yield was only slightly higher than the 1.47% starting point for the quarter, and still well below this year’s 1.74% March high point. The bond market remains fairly sanguine about longer-term inflation and, for that matter, regarding credit risk. High yield (junk) bond spreads remained tight, with the Barclays Capital U.S. Corporate High Yield Index trading 256 basis points above the 10-year U.S. Treasury Note yield by quarter-end, well below its 421 bp average over the past decade. We are watching credit spreads closely, as a potential leading (or at least coincident) indicator for equity markets stress. Credit Suisse research indicates that high yield credit tends to peak around six months ahead of major turning points in equities.(5)
A sustained move higher for interest rates could mean at least temporary pain for stocks and bonds. Earnings growth has been superb, with S&P 500 projected 2021 earnings now pegged at $198 per share versus $164 at the outset of the year, nearly 21% higher. This has taken the price/earnings ratio for the S&P 500 down to 21.7x from 22.8x, still elevated versus its 16x long-term average. Investors are willing to fly premium class in this market in part because of low rates. Savita Subramanian, Bank of America’s head of U.S. equity and quantitative strategy, compared the S&P 500 to a 36-year, zero-coupon bond, meaning the Index is vulnerable to rising rates. “Any move higher in the cost of capital via interest rates, credit spreads, equity risk premia, that’s basically going to be a huge knock on the market relative to the sensitivity we’ve seen in the past,” she said. (6) How huge a knock will ultimately depend on a number of variables, including whether earnings growth can hold up in the face of rising costs.
It was a summer of tough love in Beijing. At the end of June, ride-hailing company Didi, boasting nearly 90% of the Chinese market, went public on the New York Stock Exchange (NYSE). Didi handled roughly 25 million rides per day in China during the first quarter of 2021, compared to 16 million globally for Uber.(7) Two days after Didi’s initial public offering (IPO), regulators in China ordered app stores to remove Didi pending a cybersecurity review, and instructed Didi to halt new registrations. The stock quickly dropped nearly 20%, and closed Q3 about 44% lower than its IPO price, undermined in part by China’s ambivalence toward its tech companies listing their shares overseas.
In July, China banned companies that teach the school curriculum from making profits, raising capital, or going public. By doing so, they upended China’s $100 billion education tech sector, and left foreign investors in limbo. A month later, regulators announced new rules for China’s videogames industry, including limiting minors to one hour on Fridays, weekend days, and public holidays. This after Chinese state-owned media described videogames as “spiritual opium.”
The list of regulatory crackdowns goes on. Meant to ensure common prosperity and wrest some control back from (largely) tech companies, this campaign has unsettled market participants and renewed doubts about investing in China. Most major equity markets posted double-digit positive returns over the first nine months of 2021, but the MSCI China Index declined 17.6% in U.S. dollar terms. Internet stocks Tencent and Alibaba account for nearly 24% of the Index, and both stocks have felt the pressure of Beijing’s regulatory roulette.
San Francisco-based investment group Matthews Asia has been investing in the region for over 30 years and ridden out regulatory cycles before. In August, their chief investment officer, Robert Horrocks, said he doesn’t believe the recent flurry of regulatory moves has changed the absolute investment case for China.(8) Horrocks noted that some of the well-known Chinese stocks were trading at 20% to 30% discounts on price-to-earnings ratios versus global peers, while acknowledging that China will continue to be active on the regulatory front. He also pointed out that regulated companies in China enjoy a bit of a competitive moat, in that China wants a limited number of large companies to help them control what they perceive as inappropriate outcomes from pure market competition.
Beijing’s regulatory reawakening has clearly rattled investors and upped the perceived risks to investing and operating in the world’s second-largest economy. China’s sheer market size remains tantalizing for U.S. multinational corporations, but the central government’s increasingly heavy-handed approach may sideline some. From an asset allocation standpoint, China’s slowing economic growth and heightened political risk does give us pause. Investing in the region may require more nimbleness in the near-term, with colder winds blowing from the eas
1 One basis point (bp) equals 0.01%.
2 “Why migrate to the AWS Cloud?”, www.aws.amazon.com/cloud-migration, February 2018.
3 “Fed Chair Powell calls inflation ‘frustrating’ and sees it running into next year,” www.cnbc.com, 9/29/2021.
4 “Labor costs and US equities: Temporarily transitory,” Goldman Sachs Portfolio Strategy Research, 9/13/2021.
5 “Global Equity Strategy: Credit remains the risk to equity,” www.credit-suisse.com, 9/21/2021.
6 “BofA’s Subramanian Likens S&P 500 to 36-Year, Zero-Coupon Bond,” www.bloomberg.com, 9/9/2021.
7 “The Rise and Fall of the World’s Ride-Hailing Giant,” www.nytimes.com, 8/27/2021.
8 “China’s Regulatory Announcements Part II,” www.matthewsasia.com, 8/19/2021.