“Use only that which works and take it from any place you can find it.” (Lee Jun-fan)
Central banks, belatedly, have adopted THE key revisions to monetary supply in order to dampen inflation.
US M2 peaked in March 2022 at $21.74 trillion. By July 2022, M2 was reported at $21.7 billion, relatively unchanged on the year. The current shift in M2 policy towards absolute stability of supply in 2022, with a trend indicating modest contraction, ENDS a 4-year period of double digit annualized M2 increases, a four-year timespan that resulted in US money supply growing from $13.8 trillion to $21.74 trillion at the peak.
A 57.2% increase in circulating money supply, over four years, chasing after a relatively finite amount of real estate as well as goods and services that producers are incapable of growing apace, led to a bidding up of every necessity and want in life. The primary driver of inflation is NOT, as is oft reported by the media, an absolute shortage of goods due to Covid-19 supply chain interruptions; rather, the pernicious 12% annualized compounded injection of money into the economic system, over 4+ consecutive years, chasing after goods whose production rates could not possibly be ramped up sufficiently to balance the supply of circulating currency, no matter how hard any manufacturer tried, is the root cause. Central bankers, undoubtedly badgered by governments, chose employment stability over price stability. Now, both demand-push and cost-pull inflation are evident throughout the global economy; thankfully, they may be addressed via conventional means.
The use of rolling supply contracts has served to buoy food manufacturer profits during a time of rampant inflation.
Global multinational food processing industry participants base their production schedules upon long lead times to assure supply and, wherever possible, to solidify unit variable costs. Central to the business model is the practice of hedging inputs. Almost all substantial food manufacturers engage in rolling contracts; they purchase an entire year’s supply ahead of time, at fixed prices with scheduled deliveries to ensure that production is optimal and to remove uncertainty. Nothing is left to chance, when companies do not hedge, they do so with the deliberate understanding of potential impacts upon the profits to be earned or foregone.
Inflation has impacted certain components in the global food manufacturing process, to be sure. One year’s inflation in edible raw inputs isn’t one of those culprits.
Transportation of finished foods has become considerably more expensive since the pandemic and freight surcharges have been quickly passed through to the producers. Wages have increased, packaging costs have increased, machinery and equipment service costs have shot up and the utility costs have increased alarmingly. All these expenses will normally erode profit margins. However, under the protective covering fire of media reports on raw commodity ingredient prices skyrocketing, food producers were able to opportunistically increase prices sharply, well beyond actual inflationary pressures. What consumers and politicians fail to understand, because they are not fully cognizant of raw material hedging, and because manufacturers have not reported on hedge book contractual mitigation, is that the reported key driver of price increases, the “commodity” food products used to manufacture staples such as cereal, pasta, processed foods, etc.; those agricultural raw inputs for most producers didn’t budge one dime in price over the bulk of the production year. .
The difference is one of perception and timing; media reported that food agricultural commodities increased by “X” percentages based upon spot pricing, or even on futures pricing, but for the large multinational food companies, their hedging assured a supply of inputs at pre-inflationary prices. Therefore, larger food producers protested about inflation yet earned abnormally high profits for a time.
Delayed impacts of rising costs, due to commodity hedging, will finally catch up with everyone in 2023, likely well AFTER the current inflationary peak.
Financial markets have an obsession with hedging, and this represents a timing issue for central bankers who attempt to combat inflation. Hedging of food inputs doesn’t eliminate inflationary pressures, it merely amortizes shorter term impacts over extended periods. Contracted hedge books will virtually ensure that inflation, in the most talked about component of the consumer spending wallet, food, will persist into 2023, even while other areas of spending witness demand stability due to tightening money supply.
Food manufacturer profit growth may abate in the year ahead as new hedges are contracted.
A mismatch in the timing of raw input price increases at the producer level vs current consumer prices charged is creating windfall earnings for food manufacturers in 2022. Absent further food price hikes by producers to consumers, profit growth may stall out and even potentially reverse in 2023. Coming 2023 hedge contracts will reflect current commodity prices and represent a highly material increase the over the 2022 prices paid for raw food commodities, the 2022 contracted pricing was signed off in 2021.
For multinational food companies, their unit cost of production will shoot up apace through 2023; potentially the expense peak will take place a full year after consumers first were notified by media about inflationary pressures within the food supply chains.
The interests of food manufacturers and consumers are no longer even remotely longer aligned.
Within food businesses producing the bulk of packaged calories for consumers on the planet, their answer to stretch a 1-year earnings windfall over an extended duration will be through mining out a thick vein of naivete, attempting to raise prices yet again under media cover, buying influence with contracts for increased ad spending and increased political lobby expenditures. Shareholders get angry and executive bonus awards are minimized when profits fall; a powerful incentive exists for manufacturers of food to attempt to pass through the input costs for another year so as to not experience a profit reduction.
To put it into more cynical terms, food companies’ interests are best served by promoting stories of rampant inflation, even after input costs stabilize or decline. A sustained campaign of disinformation and spin, all for the purpose of supporting further price hikes on their output, serves their ends. They will combine “shrinkflation” (quietly reducing package sizes), ingredient substitution as well as further price increases in order to support profit gains.
Whether the food giants are successful, or will suffer blowback, when attempting to foist further increases upon the public while headline commodity prices stabilize, remains to be seen.
Equity markets are now pricing in a soft landing, not a hard fall.
Gradual contractions of circulating money supply are a battle tested inflation fighter. Utilization has historically produced a reduction in rates of spending growth at both the consumer and manufacturer level. Were major governments to also rein in spending, a combination of restrictive fiscal and monetary policies would knock the stuffing out of demand and could lead to a hard landing.
A more delicate balancing act is currently underway whereby only a key monetary lever is being applied while fiscal policy continues to promote growth. This suggests that governments are quite tolerant of inflation behind the scenes, until evidence to the contrary would come forth indicating that traditional monetary policy levers will fail.
The looming and only remaining issue now declaring that inflation will sooner, rather than later, stabilize, are the trillions in global commodity hedge books that must still be amortized into production costs over the coming year; M2 restriction should prove effective in reducing the absolute rate of inflation going forward, but newly contracted input prices will need to flow through to the consumer before we all settle into the relative disquiet of a world that is uniformly 40% + more expensive than it was just a few years ago.
This 15% plus decline in the DJIA thus far in 2022, which represents a better proxy on overall producer and consumer markets than either the S&P500 or the NASDAQ indexes, suggests that 2023 will represent an earnings trough. Retail investors look behind (they tend to extrapolate trailing earnings into the future) while institutional investors tend to look ahead. Institutional portfolios are valuing equity markets with a somewhat reduced earnings capability for 2023. A 15% decline in overall equity markets sounds awful, but from a perspective of a soft landing, that’s an easy obstacle to overcome. Over and above that equity index decline is the aspect of a valuation compression; most companies worth owning are still generating profit increases, all the while being hit by share price drops. Even a soft landing isn’t painless, while it speaks to degree or magnitude of a drop, it doesn’t address the duration of that decline.
In order to envision a hard landing, employment numbers would have to get hit, because that is the only current indicator yet supporting the present valuations based upon interest rate hikes. All hinges upon employment figures, because consumers need to earn elevated incomes to be able to afford the far more expensive consumer basket, without adding additional debts and potentially defaulting upon the same.
A go-to defensive sector in large cap markets, health care insurers, remains favored by institutional investors.
Health care insurance firms/HMO have continued to buck the tide against a declining overall equity picture for 2022. Humana recently articulated a 2025 goal of increasing gross earnings from pro-forma $25 per share for 2022 to $37 by the end of that year, or better than 14% compounded for that three-year timeframe. In the coming weeks, Unitedhealth Group should, more likely than not, offer up similar growth guidance; such an achievement could take the annualized 2025 dividend payment to almost $10 US per share, from here.
Market approval of Humana’s guidance took that stock, in a very soft period, to an all-time high and Humana is far from the largest player in the HMO space. A 14% compounded 3-year increase in earnings during a strong economic expansion seems just OK, until investors become aware that 14% is a fantastic growth rate during a period of perhaps a year or more of corporate disappointments, hence the move towards institutional accumulation.
Forgive my use of a hackneyed phrase: potential exists of a “new-normal” in consumer pricing for the foreseeable future.
Things cost a great deal more than before the pandemic. They will continue to rise in price further for a while. These increases may persist even while inflationary pressures are assumed to be waning at the basic commodity level; delayed cost pressures due to manufacturing hedges plus corporate profit motivations will be the culprits. As an offset, unless reserve banks withdraw all the money supply added to the system for the past half decade, we collectively have a great deal more capital to pay up for wants and needs.
By 2023, pricing for everything will have largely caught up with the 4-year money supply increase. This will be the new normal and griping aside, we shall adjust. Governments are acquiescent to the current central banker experimentation, despite what is undoubtedly a highly alarming top line inflation number. Any more aggressive responses will most certainly produce a hard landing; policy makers seem to be of the implicit understanding that things cost more but we have more and therefore it is almost a wash. Governments are truly unconcerned about price increases now baked into the system, they just want assurance that when pressed, traditional levers will function as they have in the past.
Demand push inflation typically reacts quickly to money supply reduction; timing delays with agricultural and producer commodity hedges mean that cost-push inflation could seem to be stubbornly persistent and may give investors pause for a time. The risk for central bankers is that external pressures to do more may lead to a money supply contraction overshoot, when what is truly needed as M2 contraction occurs, is patience.
“Long term consistency trumps short term intensity“ (Lee Jun-fan)
If a hard fall were as likely as a soft landing, institutions would now be going-to-ground with cash and dumping HMO companies on strength, selling the highs, even on news of increased guidance; there is no cover in any industry, in any sector, in any stock, under a hard landing. After all, dividend yields in the HMO sector cannot compete with treasuries so yield cover is not the driver of investment decisions.
Yet, traditionally defensive sectors with a growth component, such as HMO businesses, are doing just fine, holding their earn, some continually taking out 52-week highs and that remains inconsistent to any punditry opining on a hard landing recession. Equities that deserve a premium valuation in this market are being appraised on the basis of “earnings growth certainty” rather than ill-defined promises of future growth; even the slightest crack in a growth story will result in a risk repricing.
Defensively themed investments featuring highly predictable earnings growth now look comparatively more attractive than formerly high growth industries and are bid accordingly. Secular growth investments are being discounted, ever so gradually, to account for higher interest rates. Businesses featuring a cyclical component or sensitivity to further money supply contraction are being marked down, even when last quarter’s earnings appear to make them incredible bargains; the caution remains that prospective investment owners need to focus upon future profitability, not trailing profitability.
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