Speaker 1 (00:02):
Hello, and welcome to Actively Speaking. I'm your host, Steve Bleiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.
Speaker 2 (00:16):
Well, welcome back everybody to another episode of Actively Speaking. We took a little break in January, but we're back now in February. Uh, and we're gonna talk about inflation again. We talked about this in June of last year with Kevin Hebner. And, uh, on that occasion, we were really talking about inflation from a macro perspective and trying to figure out where it was going and where we're gonna see a revival and inflation. Well, eight months later, we can conclusively say yes, we have seen a pickup in inflation. Uh, and, you know, the most recent, uh, headline inflation numbers running at over 7% a year. Uh, and so we thought it would be helpful to actually now talk about inflation more from a micro perspective. And how does inflation affect individual companies? What impact does it have on their income statements or their balance sheet? And, uh, to set the table?
Speaker 2 (01:02):
Uh, I'll, I'll say a couple of things, but one, um, is obviously we, we talk about inflation as a single number, which is at the, you know, the rate of change in the price of a basket of goods that's in that consumer price index. But of course, inflation is not always evenly distributed. Some things are rising in price faster than others. There could even be things that are still falling in price. And so obviously that means that the impact on in of inflation on companies is gonna vary quite a bit from company to company, depending on the nature of their inputs and the nature of their outputs. So that's number one. And number two, I was thinking about this in prep, preparing for this episode. I was thinking back to, uh, the last time that we had inflation like this. 'cause, you know, the headlines are telling us that we're at a 40 year high in inflation.
Speaker 2 (01:49):
So 40 years ago, I was just entering business school in 1982, and we had just had three years in 79, 80 and 81, where inflation in the US was in double digits, you know, meaning 10% or higher. Uh, and at that time, I remember there was kind of a cottage industry in the academic world of, um, of professors trying to see whether the market saw through the changes in, in accounting rules that companies were going through. You know, and the point is, uh, I haven't even thought about this in so many years because inflation's been so low. But, uh, so if I say these terms, fi, FO, and life o that's gonna ring bells for people that maybe haven't been wrong in a long time. You know, which refer to first in, first out accounting for cost of goods sold versus last in first out. And, you know, if, if you've bought things over the course of a year that you had in inventory, and some of them cost a lot more because prices went up during the course that year, then which ones you choose to, uh, recognize as having been sold, uh, depend it will impact your, your accounting profit.
Speaker 2 (02:54):
Of course, it doesn't necessarily impact your cash flow. And so at that time, some managements thought that they could boost earnings by doing this, you know, accounting change in how they accounted for inventory. And professors were batting that down constantly writing papers, pointing out that the market didn't really seem to be fooled by that. But anyway, that's just, uh, you know, something we haven't had to think about in a long time is how do you account for your inventory if prices are going up every month, uh, while you're, while you're stocking your inventory. So, to help me today, I've got, uh, two analysts here at Epic, uh, who have both been on the podcast before. We've got, uh, Nick Petrov, uh, who covers financials. Hi, Nick. Hello. And, uh, and Glen Petra, who covers, uh, a lot of kind of consumer facing companies. Hi, Glen.
Speaker 3 (03:38):
I, you speak of inputs going, maybe going down in price. I, I wanna know what those are because I I I've not heard about any of those.
Speaker 2 (03:45):
<laugh>. Yeah. Well, maybe we'll find some. Um, but I, we're gonna, we'll start with you, Glen, because again, I think that the companies you tend to cover tend to be more things, companies that make physical goods that the consumers are familiar with. So I think maybe it'll be easier for people to get their, their heads around on, on companies like that and how inflation affects them. So why don't you get us started and talk about for some of the, some of the industries you look at. Uh, how, how is inflation affecting, you know, things like margins, uh, profitability, uh, of, of the companies you look at?
Speaker 3 (04:17):
Sure. Um, yeah, you're, you're correct. I, I largely look at, uh, consumer companies, uh, generally more towards your traditional consumer staples, um, than anything else. Um, and, you know, inflation is, uh, is seemingly everywhere right now. It's, it's the, the, the hot topic on, on many conference calls and, and how companies are, are managing through it. And, you know, the, the short answer is, uh, I think, you know, in general, a little bit of inflation is, is manageable. The, the, the sorts of inflation we're seeing today. You mentioned, um, high single digit, uh, for consumer basket. But, but on the input side, you know, a number of companies I speak with are, are seeing double digit, if not even high teens, uh, levels of inflation across their entire, uh, basket of, of cost of goods sold. So, uh, it's significant. And, uh, you know, I think in the short run, margins go down, um, because that level of inflation cannot be passed through that quickly. Um, and the companies all play, you know, largely the same playbook of what to do, uh, which is, uh, raise prices. And there's a number of ways that, that companies do that. Uh, some more, uh, uh, explicit than others. Uh, and then they dial up their, their internal cost, cost savings measures, and, um, and, uh, they, they cross their fingers and hope, hope things get better, um, because it's, it's obviously highly disruptive, um, to, to their, uh, p and l, uh, as well as, um, the potential consumer value proposition that they're trying to present.
Speaker 2 (05:56):
So do you see differences across industries in terms of, well, I'm thinking in terms of like, um, you know, elasticity of demand. If, if you're a company that makes something that is really kind of an impulse purchase, yes, it might be, it's gonna be harder to pass on a price increase versus something that's people just have to buy. And, uh, if it's going up in price, well, they're gonna have to rejigger their budget a little bit, but they really still need to buy it.
Speaker 3 (06:20):
Yeah, I think you bring up an interesting point, which is the elasticity of demand. And, you know, interestingly, almost unanimously, um, virtually all companies, um, and I'm struggling to think of one, um, to the contrary to this point, elasticity has not been significant. Um, and I think part of that may be a function of, uh, consumer balance sheets, uh, through the pandemic. Um, they dele, uh, and there was a lot of stimulus money that, that made its way to the consumer, particularly in the us. Um, so that may be, uh, a, a factor at this point. Um, and it, it may also be that it's obviously been so widespreadly, uh, uh, so broadly reported about inflation that perhaps, uh, consumers are expecting it. So, you know, we we're not at the point where the consumer balance sheet is, is, or consumer incomes are under such pressure that, that they are yet trading down. But, but we'll see. I think, um, you know, there's still a lot of pricing that still has to make its way through, through the system, um, and, and make its way to the consumer. Um, so, so that might be something that we're dealing with, you know, in six months time or so.
Speaker 2 (07:30):
And, and are there, are there any companies you follow where you can think of that inflation's actually good for them?
Speaker 3 (07:37):
No, uh, certainly not inflation to the level that we're seeing it. I think, you know, generally a little bit of inflation pretty good for, you know, a retailer might not be such a bad thing because it helps support, like, for, like sales growth potentially gives them a little bit of, uh, leverage on the, or operating leverage, uh, further down the, the, the p and l uh, or their income statement. Um, but I think what we're seeing today with the more rapid inflation, that becomes harder because you're, you're at the point, particularly as it all works its way through, as I said a moment ago, is you might get to the point where you're actually destroying demand, and that's not particularly good for anybody. Um, you know, I think a little bit of inflation is good. It could potentially spur for food retailer, it could spur some down trading to, um, a company's private label product where they tend to make higher margin, um, or higher penny profit. Um, but, you know, I think the level of inflation we're seeing today, if it, if it destroys demand, it's not, it's not necessarily a positive.
Speaker 2 (08:41):
Okay. Well, I, I wanna bring, uh, Nick into this conversation. Uh, so Nick, you cover financials, which is of course a a pretty broad sector with many different types of companies. Uh, and, uh, be curious to hear whether you think the impact on the different segments within financials, uh, are different. If, if inflation impacts companies differentially within the sector, why don't, why don't you start by talking about, uh, banks and how does inflation affect banks?
Speaker 4 (09:05):
Sure. And I think I can probably paint, uh, a little brighter picture than, uh, Glen, uh, because in inflation, and, and of course it depends on the nature of inflation, the duration of it, the reaction of central banks, government, and regulators. But, um, if it's steady, um, with, with a, uh, combined with a gradual tightening cycle, inflation can be actually quite positive for banks. And, um, you know, on a side note, I I, I remember that only 12 years ago, we, we were talking about deflation and the negative impacts that that would have, um, on the economy, and particularly in the financial space, banks, uh, being, uh, uh, the most affected. Um, and, and now the tables have turned, at least for now. Um, so that, that, um, would suggest that maybe we have some, uh, some positive developments within the, the banking sector as well.
Speaker 4 (09:58):
Um, now that those can stem from, from a, a couple of factors, but the most important one is that, um, as, as, as, um, balance sheets grow, nominal profits grow, borrowers have growing needs, um, uh, for, uh, uh, credit formation, and that goes straight through, uh, banks, balance sheets, lending growth, um, is, is definitely gonna be positive again, in nominal terms. Interest rates, again, depending on how the, uh, fed will react to this, but increasing rates in general would be positive. And then, um, I fully expect that if the inflation is, um, gradual, uh, we're gonna have relative stability of, of, uh, uh, credit quality for extended period of time. So this, all of this is a recipe for, uh, um, pretty positive developments in the industry. I would also say that positive impacts will be amplified its current bank's balance sheets. Um, and I'll give you, give you an example.
Speaker 4 (11:04):
Uh, currently, uh, the major banks in the US have anywhere between five to 15% more excess cash, um, than they had pre pandemic. Um, and, and we, we all know that during the pandemic, uh, deposits grew faster than, uh, than loans. And so, um, that, that's clearly a very positive effect. Um, the estimates out there are for, um, you know, if, if that excess cash were to be deployed, uh, for balance sheet growth, whether it's for loan formation or investing that in, uh, government or other securities, we could have net interest income for banks increasing between, uh, two and six or 7%. Um, and that's gonna go straight down to, uh, to the bottom line. Um, you know, and, and when, when you think about the industry, obviously, uh, there are different, um, banks, some are that have different lines of business. Um, I'm thinking of, uh, the likes of Bank of America, for example, where they have investment banking businesses, they have lending businesses, they have wealth management businesses, and all of them will benefit from, um, the trends I'm, I'm describing. Um, finally I wanna say that, um, you know, as, as interest rates, I mentioned interest rates are positive, generally speaking, um, banks have guided for about 15% increase in profits for about a hundred basis points, parallel shift of the curve now with inflation. And we expecting the shift to be parallel, at least not in the near term, but over time it might be. And, uh, that certainly, um, is, uh, is a positive.
Speaker 2 (12:50):
Okay. And, uh, so let's, let's turn to some other segments of the financial sector. There's a, a big chunk of it's also is, is insurance companies, and of course, even that industry has different kinds of insurance companies. So how does, how does it pick up and inflation affect them? Sure.
Speaker 4 (13:06):
Now, I mean, if, if you look broadly at the financial space, I would say insurers, life insurers would be, uh, the, uh, the greatest beneficiaries of, um, again, measured sustained inflation, um, versus property and casualty reinsure companies probably be worse affected with banks being in between. Um, because again, the, the effects on banks will be positive, but if you have credit quality deteriorating, you will have negative effects. Now, life insurers are, I mentioned, are the, the ones that are likely to benefit the most. Um, and that's because their insurance premium grow with income. Um, and, uh, when interest rates are higher and, uh, overall asset balances grow, uh, nominal portfolio returns, whether it's equity or fixed income, ultimately exceeds the claims and the assumed liability returns, in other words, realized, uh, promised or guaranteed returns on the, on the liability side. Um, to put it in simpler terms, higher employments and increasing wages do benefit, um, uh, group benefit businesses.
Speaker 4 (14:20):
Higher salaries lead to higher, uh, 4 0 4 0 1 K balances, and a lot of those send flow through, um, insurance company, um, um, management books, um, asset management books. Um, you know, I I I'm thinking of, um, equitable, uh, the life insurance company, um, which, um, has a large individual retirement business that would certainly see balances growing, um, as people incomes grow in nominal terms. Uh, MetLife, for example, is, is another life insurance company that, um, has a, a, a very large group benefits business. And as salaries and employment grows, um, uh, the balances within, um, uh, those group benefits grow as well. The, the other benefit for life insurance companies certainly would be interest rates, given that the liability and the assets for those companies are kind of longer term. Um, as I said, the liability interest embedded into, um, um, the underwriting assumptions are more or less stable versus if asset returns grow in again, in, in, um, um, um, non-real terms, um, then the life insurers, uh, would, would benefit.
Speaker 4 (15:37):
Um, now it's, it's not all positive. There, there could be a negative impact, and it's mostly related to their investment books. If, if equity markets ultimately fold under significant, um, uh, inflationary pressure, uh, or credit quality deteriorate, these companies invest in credit and in equity. And, um, you know, I could tell you that a 10% change in equity markets could have anywhere between one and 6% immediate impact on, um, the profitability of, of life company. Um, I, I would like to point out the, the property and casualty, uh, part of the, uh, insurance industry. Um, and within that, I would wanna further segment into short tail versus long tail, um, policies, because the impacts will be different. Uh, a typical short tail, uh, policy would be the ones in the personal lines like auto or, and homeowners where, um, similar to what Glen was describing about his companies, um, the cost inflation, um, rises very quickly for these companies, and it takes time for them to pass that through increased premium prices. So the property and casualty short tail insurance companies, um, would, would have very similar impacts to those that Glen was describing for his companies. However, the long tail ones could be, um, uh, beneficiaries in the near term. Uh, if the inflation proves to be transitory, no matter how high it's, if it proves to be transitory.
Speaker 2 (17:08):
I'm just gonna gimme an example of what, what is a long tail insurance policy?
Speaker 4 (17:12):
Yeah. Um, workers' comp is, is a, is a very good example of that. Um, and the reason, uh, for that is that as you would imagine, um, if an employee gets hurt, um, on the workplace, um, you could go into long-term disability and the cost of long-term healthcare for that person, um, would, um, escalate over time. And, uh, so the insurance companies could actually face reserve problems, which are balance sheet. They're not just profitability problems in the near term, but, um, reserve problems, which would lead to, um, equity problems. And some of them may resort to actually either, um, uh, reinsuring significant part of their book and therefore giving the, their profitability away or having to raise capital in order to support, um, the balance sheet. So, um, it, it is complicated, but I would say that in general, uh, life insurance companies will fare very well. Property and casualty companies may suffer on the short end if you have a transitory inflation, um, or may, may suffer on the long end and have balance sheet issues, um, for, for the long tail, um, lines of business.
Speaker 2 (18:28):
You know, you mentioned, um, in, in, you were talking at one point about, you know, like employee benefit programs that are administered by insurance companies, and what happens to people's wages are going up because inflation, and that's, that's actually something that everybody worries about is, you know, that what makes inflation longer lasting or harder to get rid of is, is a quote, wage price spiral if people start building it into wage growth expectations and demanding higher wages. Uh, I'm curious for both of you, I'm just gonna turn back to Glen first. We've just come through an earnings reporting season, you know, for the end of 2021. What are the companies you follow, what have they been saying about, specifically about, you know, are are they seeing wage inflation pressure yet, uh, come, you know, do they, do they feel the need to be, uh, what are they doing on the, on the wage front?
Speaker 3 (19:13):
Yeah, I think, um, unsurprisingly, uh, in light of everything going on in the world, they are definitely seeing, uh, wage, I wage, uh, inflation pressure. Um, and, uh, there's definitely a war for talent going on, uh, across a number of industries. And, and the cost, the cost for, for, for employees is, is rising. So that's just, that's just on top of the, the cost of goods inflation that I spoke about earlier. So I, I'm not sure that it's germane to, to my industry. I'm sure, um, Nick and I think other banks have spoken about, uh, a war for talent going on and, and the need to to pay people. And we've seen reports of that from certainly the large money center banks, and I'm sure Nick has many more, um, examples of that as well. But it, it seems to be, uh, you know, in light of everything that happened during the pandemic, and we've heard a lot about the great resignation and, and the labor participation rate, um, having come down over the course of the last few years, that it certainly have a, a had a ripple effect, uh, across industry.
Speaker 2 (20:12):
Yeah. Nick, Nick, what are you hearing?
Speaker 4 (20:14):
Yeah, I would say war for, for, uh, talent, uh, is, has been the name of the game of reporting seasons la last couple of quarters, particularly for the large money center banks. Um, and there's been, there've been two sources for that. One has been the investment banking business, which has done very well because volatility in the markets has been significant. Um, uh, transactions have been significant. So, um, um, IPOs and, and those have been, uh, uh, plentiful and, and investment bankers like to be paid. Um, so, so that has caused significant increase in, in compensation, uh, in addition to the war for talent. The second, uh, the second reason for wage increases within large money centers has been technology. Uh, banks have been, uh, spending enormous amount of money. I'll just give an example with, uh, JP Morgan over the last several years, they've been spending north of 10 billion, uh, on technology. And, um, on one of the latest calls, the CEO was talking about bumping that number to close to 15 billion. Um, a lot of that has gone into wages and again, uh, um, trying to get as much talent as they can, um, in, in, in order to, um, implement some of the technology strategies that they had, competition from, uh, FinTech companies, so on and so forth has been strong. And I think that the infl, the general inflationary environment has allowed the management teams to now spend, um, so clearly, clearly a trend that we're observing
Speaker 3 (21:53):
And, and, and not to be too downbeat, um, I, I would say that, uh, there have been several companies, particularly those that, uh, employee hourly, uh, hourly employees here in the United States, uh, whether it be in restaurants or some, some retailers have spoken about the labor availability improving, um, a little bit, uh, in the last, let's say month or so, which has maybe a result of, of omicron having, um, seemingly hopefully burned out quite quickly. So, so maybe we're beginning to see some easing on some of the labor, um, constraints, particularly at the lower end of the, of the wage spectrum. You know, those people like to get paid too, not just investment bankers.
Speaker 2 (22:37):
Um, well that, so that raises an, um, I think one, maybe one last, uh, topic for us to talk about, um, which is, if this does turn out to be I, 'cause Glenn you're talking about, you know, labor shortages, possibly showing signs are starting to ease as Omicron fades, it, it raises the question of, so what happens if we, if the forces that we're pushing inflation up abate a bit, like, uh, you know, disruptions in the labor market, disruptions in supply chains, you know, uh, there's a definitional issue here in inflation, as we use the term is really, uh, it's like a rate of, of change in prices. Uh, and so we've, when we say 7% inflation, you know, so this, this basket of goods is the, the average of all the prices together is rising. It's not just one price going up relative to others.
Speaker 2 (23:23):
Um, but what if this stops? It doesn't, you know, it, it's like, it's not like the prices are gonna go back down just because these forces, uh, abate, um, you know, it, the rate of inflation could go to closer to zero. It could go back to say 2%, but that we're still stuck at this higher price level. And, and the changes in, of course, in relative prices, some changes in relative prices have taken place over this time, even as the average price level was rising. Um, I'm curious, like, are are companies, uh, you know, are, are they facing particular challenges because of that where, um, you know, prices have risen and they're just gonna stay high for some, some things? Or did, are they expecting prices of some things to go back down, perhaps?
Speaker 3 (24:07):
Yeah, that's a good point, Steve. You know, I, I think, um, you know, I, I don't think, you know, its inflation is, is tends to be transitory, um, to use that word, uh, that prices necessarily go down. But I, I mentioned earlier about ways that companies will, will raise prices, and I, I would say that there's a number of different ways that companies can raise price. The, the first and and blunt method is a straight list price increase, um, but they also reduce promotional levels. So the percentage of sales that are done on promotion would fall theoretically, uh, as low as zero. Um, they can reduce the size of the package, um, which would probably be be more permanent, uh, or they can innovate and try to introduce, uh, products with, with, uh, new attributes or benefits that consumers, um, would be willing to pay for. You know, I don't think you, you necessarily get list price reductions, but ultimately what will happen, um, it's a competitive world and promotional levels will increase, uh, retailers will exert some pressure potentially on, on manufacturers of goods, um, to, to increase promotional levels. Um, and, uh, you, you, I I don't think margins would necessarily get a permanent step up, uh, because of pricing falling you that would eventually get competed away in the marketplace.
Speaker 2 (25:24):
Right. Nick, is my question relevant at all to your world?
Speaker 4 (25:28):
Yeah, absolutely. I, I would say that transitory inflation could well be a gold deluxe scenario for, for financials. And, and the reason is, um, that for banks, for example, I, I I was talking about, uh, their ability to deploy excess cash that they have accumulated during the pandemic, if they're able to do that and at higher rates without causing, uh, credit problems. Uh, that means profitability for the duration of the loans that they generate, um, that would be at higher levels than the current, uh, runoff book. So that, that is a very good scenario, uh, for banks, for insurers, um, if you remember me, uh, talking about cost inflation upfront, um, being a problem, uh, because it takes time for property and casualty companies, for example, to put through premium increases. Now, if the transitory inflation is just long enough, if we can engineer it to be just long enough, that would allow these companies to increase premium.
Speaker 4 (26:31):
Uh, and, and, and then if we have leveling off of, um, um, uh, cost inflation and or declining, then that, that's, uh, uh, premiums are very sticky once they go up. It takes years for them to go down just like they are sticking on the, on the, um, upside as well. Um, so that could be a very positive scenario. And more importantly, it's, uh, the transitory inflation is unlikely to hit, uh, reserves and therefore the balance sheet of the longer tail, uh, books of business, uh, like consum, uh, um, workers' compensation, uh, which again would be a very positive area.
Speaker 2 (27:09):
Okay. Well, I think we've, um, probably run out of time. Uh, I wanna thank you both, uh, for joining me. Thanks Nick, and thanks Glenn. Uh, and, uh, to our listeners, if you enjoy listening to this podcast, we'd appreciate it if you could give us a good rating on, uh, whatever platform you get the podcast from, and, uh, look for another episode in the near future. Thanks very much.
Speaker 1 (27:30):
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Speaker 5 (27:46):
The information contained in this podcast is distributed for informational purposes only, and should not be considered investment advice or recommendation of any particular security strategy or investment. Product. Information contained herein has been obtained from sources believed to be reliable but not guaranteed the information is accurate as of the date submitted, but is subject to change any performance information referenced represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this presentation are forward-looking statements and are based on epic's research, analysis, and assumptions made by Epic. There can be no assurances that such projections, targets or estimates will occur, and the actual results may be materially different. Other events which were not taken into account in formulating such projections, targets or estimates may occur and may significantly affect the returns or performance of any accounts and or funds managed by Epic.
Speaker 5 (28:39):
To the extent this podcast contains information about specific companies or securities, including whether they're profitable or not, they're being provided as a means of illustrating our investment thesis. Each security discussed has been selected solely for this purpose and has not been selected on the basis of performance or any performance related criteria. Past references to specific companies or securities are not a complete list of securities selected for clients, and not all securities selected for clients in the past year were profitable. The securities discussed herein do not represent an entire portfolio, and in the aggregate may only represent a small percentage of a client's holdings. Client's portfolios are actively managed and securities discussed in this podcast may or may not be held in such portfolios at any given time.
