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'Consumers Rarely Notice Inflation'

Published 10th Mar 2022 by James Taylor, Caitlin McCartney and Ateeqa Asif

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More than a decade of printing money and extremely low interest rates followed by helicopter stimulus born out of a pandemic response have exacerbated the longest bull run in history.

In that bull run we witnessed asset price inflation at the end of 2021 to a measure of (cyclically adjusted) 40x earnings in equity markets, more than double the long standing average.

While the owners of assets have gotten richer, non-asset owners have become relatively poorer, reflecting a growing wealth gap.

Overall the economy is healthy, unemployment is at historic lows and household savings are strong.

Retail is alive and well, with eCommerce absorbing the $ from bricks and mortar lockdowns of the last 2 years.

The global economy is so healthy that, in fact, a perpetual growth environment has inevitably run into capacity constraints.

In 2021 inflation was first felt by corporations, quickly passed onto the consumer and while initially touted as ‘transitory’, inflation has persisted and increased. Inflation is not only a long overdue trickle down effect from capital markets (pricing out many from property ownership for example) but has been shocked and stress tested by supply chain bottlenecks as well as other capacity shortfalls including labor and the resulting wage growth.

Energy costs have risen too. Energy prices are now skyrocketing with the Oil & Gas scarcity enforced by the isolation of Russia following their invasion of Ukraine.

War can drive inflation or stagflation, but where energy prices, commodities and utilities are concerned it is more likely to be the former.

Consumers rarely notice inflation

In this article we evaluate what inflation, and not just the consumer price index inflation we have read about in headlines lately, but how broader market inflation has created a higher real rate of inflation (i.e. it is disproportionately more expensive for you to buy a house now vs 10 years ago). Critically, what that means for the economy where we are specifically concerned with what inflation means for consumer confidence and for margins in retail and eCommerce businesses, as well as the operators and the investors that fund them.

We are specifically concerned with what inflation means for consumer confidence and for margins in retail and eCommerce businesses, as well as the operators and investors that fund them.

We also consider whether markets are \actually\ overvalued or whether they are simply baking in the inevitable rise in future cash flows, not because business is set to do well but because currency is worth less (because governments printed more currency - more on this shortly).

Earnings multiples (high valuations relative to income) could in fact be pre-emptive to the fact that future cash flows really will be higher in absolute dollar terms, due to inflation depreciating currency rather than real growth.

What if currency is worth less in the future?

Warren Buffet famously wrote in 2012 that

"...the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than US$7 today to buy what US$1 did at that time. Consequently, a tax free institution \[since tax further erodes real returns\] would have needed 4.3% interest \[return\] annually … to maintain its purchasing power."

This is a natural way to think about inflation, not that things get more expensive, but that the value of the currency has dropped. We believe currency has more or less halved in value since 2009.

Equity valuations (or ‘earnings multiples’) are how you measure the value of your business and are simply a net present value (what money received in the future is worth today) of future cash flows applying a discount rate that is typically assumed as a product of inflation expectations and by relation, expected long term interest rates. Beyond that fundamental measure, you also have market sentiment, that is the ‘opinion’ or ‘emotion’ of players in the market - that is why stocks tend to swing lower than trendlines during pessimism/panic and higher than trendlines during optimism/elation.

As a retailer, your enterprise value is the money you expect to earn in the future adjusted for that money being worth less than it would be if it were earned today.

Current multiples (the premium investors are happy to pay on current cashflows) suggest the market is assuming earnings will continue to grow forever without hindrance. Hindrances that may include collapsing consumer confidence, higher interest rates, and cost inflation that eats away at margins.

Though this can also be exacerbated by the fact that no one wants to be sitting on cash while capital markets fly.

We are in uncharted economic waters and rocky hindrances are in sight

A retailer is in the business of ‘investing’ cash into inventory which they hope to then sell at full margin and as quickly as possible. A retailer is in the business of making profit from the margin in between sale price and cost price.

An optimal retail business

1. Reduces the landed (delivered) cost of an item. 2. Minimizes markdowns (discounts, triggered by an inability to sell enough quickly). 3. Constantly improves cash-on-hand to inventory ratios (giving them flexibility to re-invest in the highest performing stock and/or marketing channels, deliver loss leaders etc.) 4. Controls operating leverage, which means reducing variable price (costs that scale with output, e.g. sales commissions, shipping/delivery) to fixed price (costs that stay the same, e.g. rent, equipment) ratios so that an increase in sales can drive a higher profit more reliably.

Further to operating optimally, retailers (like any corporate) can increase earnings by… to quote Warren Buffet once more:

“Corporations would need at least one of the following: (1) an increase in turnover, i.e. in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes; (5) wider operating margins on sales.”

The good news is leverage is extremely cheap right now, and any fixed rate loan is a good deal. The bad news is, rates must rise to stem inflation, and although war time economic catastrophes may put increased pressure on governments to keep rates low, banks will likely increase their own risk margins on lending if war and economic risk grows.

Inflation of course negatively impacts point 5, a desired wider operating margins on sales. Fortunately for retailers there are ways to optimize operations to increase earnings. These methods typically require advanced machine learning platforms to help manage customer experience and demand and inventory allocation, like products we offer at Particular Audience.

Money printing and why it leads to inflation

Following the credit crunch and economic collapse during the GFC (Global Financial Crisis 2007-09), government debt in the west reached all time highs, requiring further stimulus in domestic economies. Quantitative easing, or ‘money printing’, solved both problems by shoring up banks, appeasing lenders, and increasing liquidity. All at the risk of devaluing currency in the hope that economic growth would counteract it. What a decade it has been!