CAPITAL IDEAS: You’ll pay more, and you’ll love it!

Usually, when inflation rises, consumers change their buying habits. If beef prices rise, consumers buy more chicken. Or, if kids’ shoes are too expensive at Macy’s, parents can go to Target or Walmart. Usually this does not happen in this cycle.

I present these specific names as conceptual examples. Walmart is doing pretty well. However, Walmart’s performance is not necessarily due to consumers seeking lower prices. Walmart is a giant and has the power to keep its shelves and in-store restaurants stocked as its competitors suffer from inventory shortages. It’s not a guess. Walmart Chief Executive Doug McMillon said so on Feb. 17, 2022. McMillon explained how the company’s scale allowed him to flex against manufacturers to receive far more product.

But instead of spending less, consumers are spending more. Retail sales jumped 3.8% in January 2022, nearly doubling expectations (i.e. goods, not services, though restaurants are included, to be precise). This is not adjusted for inflation, so part of the increase in spending was due to higher costs. However, it’s more than that – US consumers are very active. Especially online. But not just online. For example, Chipotle CEO Brian Niccol said on Feb. 8, 2022 that the restaurant chain has seen no resistance to higher prices from customers. For the sake of brevity, I won’t include a bunch of other examples. The fact is, when consumers can find what they want amidst inventory shortages, they’re willing to pay for it.

My guess as to why that is (and now I’m in guess mode) is a two part theory. Both parts are based on facts. First, consumers are strapped for money. A year ago, consumers had about $1.6 trillion in “surplus money.” According to Overtakingthe excess cash level is currently closer to $2.4 trillion.

This is the fact. The assumption is that people feel good about spending more money when they have more money.

I remember a couple looking at artwork, and the wife said to the husband, “I feel nervous. We spend tens of millions of dollars now as we spent hundreds of thousands. Nice problem to have, huh? They were successful entrepreneurs and their expenses increased with their net worth. I know that sounds hyperbolic, but hyperbole gets the point across. I bet your neighbors did similar things. They get a raise and put a deck on the house. They get a promotion and buy a new car. The more I think about it, the closer my hypothesis is to reality. The plural of anecdote isn’t a given, but you know it’s true.

My second assumption is that people expect inflation to be transitory. If consumers don’t believe the higher prices will be permanent, they are less likely to seek other purchasing options. Year-on-year inflation recently hit 7.5%. According to a January 2022 survey by the Federal Reserve Bank of New York, consumers expect inflation to average 3.5% over the next three years, not 7.5%.

So what does this all mean? Because people are paying more and don’t seem to care (yet), inflation will remain persistent. Therefore, I expect the Fed to have to slow the economy more than it otherwise would to bring inflation down. A slower economy makes it more difficult to extract gains from the stock market.

I explain this to tell you this: on February 16, 2022, the Berkshire Money Management team held one of its (not so) legendary investment committee meetings. the TL; DR of the marathon meeting is that there were not many changes to be made. But there are themes we need to consider that will likely lead to future changes. The most important theme of this meeting is that it is difficult to manage high quality bonds paying 2% when inflation is two, three times or even higher than this level.

We discussed bond alternatives. Bonds traditionally play a role in a portfolio to provide income, diversify risk and reduce volatility. However, we are not going to be happy to hold certain types of bonds over the next couple of years if inflation eats away at those bond yields. I prefer to invest in stocks of companies that have things people are willing to buy at higher prices (see how I came full circle there?).

However, being 100% invested in stocks is not suitable for all portfolios. I’m considering using more buffer funds (funds that protect you from some of the market downside but potentially allow you to capture some of the stock upside). I’m also considering floating rate bonds (existing loans that adjust their rates upward in real time). We discussed additional exposure to real estate investment trusts (REITs) or utility stocks. However, if I’m looking for a bond alternative, I need more than just a favorable yield; I need low volatility.

I currently own three general types of bonds. I hold short term corporate bonds and am looking for an exit strategy. The short duration keeps them reasonably stable, but the yield is less than 2%. This will not be enough to counter the erosion of inflation.

I own Treasury Inflation Protected Securities (TIPS). Betting on inflation, in retrospect, turned out to be a good idea. But I’m not happy with the returns of TIPS compared to more aggressive bets I could have made, like some commodities. This is largely explained by the fact that the TIPS is more correlated to inflation expectations than to actual inflation. And as I mentioned earlier, while inflation is sky-high, one way or another, expectations remain relatively low.

I also own short term junk bonds. I like those, but I own enough for now.

Also discussed during the investment committee meeting:

  • I have a growing affinity for owning stocks of financial services companies.
  • I have flattened a relatively heavy weighting in technology over the past 10 months. I am more likely to continue this trend than reverse it.
  • For years, I avoided non-US based investments; I continue to resist exposure to foreign equities. It would not be unreasonable to consider holding international stocks for what could benefit from being more diversified portfolios. However, exposure to non-US equities generally added volatility and detracted from returns. Although I don’t regret this decision, the lack of diversification makes me nervous.
  • Fortunately, I’ve mostly avoided mid-cap stocks, but I still have a relatively small allocation to small caps. The allocation is small enough that we are not considering reducing it, but we are not currently planning to add to it.

For now, friends, you know as much as I do. As always, I’ll let you know if I make any moves.

Allen Harris is the owner of Berkshire Money Management in Dalton, Massachusetts, managing investments of over $500 million. Unless specifically identified as original research or data collection, some or all of the data cited is attributable to third-party sources. Unless otherwise stated, any mention of specific securities or investments is for illustrative purposes only. The adviser’s clients may or may not hold the securities in question in their portfolios. The Advisor makes no representation that any of the securities discussed have been or will be profitable. Full Disclosures. Direct inquiries: [email protected]

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