The inflation surge has dominated the narrative for equity investors in 2022. But prices will eventually peak. Surging inventories are likely to lead to deflation in prices for goods, which will affect corporate profitability and stock valuations.
After consumers have struggled to find goods to purchase over the last two years, the tide is turning. The world is about to be awash in inventory that companies will have difficulty offloading. Many will be forced to lower prices as a result. As the process unfolds, deflationary forces could ease pressure on equity multiples while putting some companies that sell goods at risk of dramatic margin declines. It’s time to consider the investment implications in areas that may see inflation peak first.
New Car Market Is Poised to Normalize
The US auto business is a good example of where this might play out. For years, purchasing a car was a negotiation that usually resulted in the consumer getting a discount on the manufacturer’s suggested retail price (MSRP). Before the pandemic, that discount was around 5% (Display). But computer chip shortages, COVID shutdowns and the war in Ukraine have combined to create broad supply chain bottlenecks that limited automotive production globally.
Car dealers have been laughing all the way to the bank. With the upper hand in negotiations, dealers have enjoyed average selling prices exceeding 102% of MSRP over the last year. Yes, you read that correctly—dealers are getting more than ask due to limited inventory and “market adjustments.” In other words, the exact same car costs the consumer 7% more than usual. This trend has contributed to inflation, while dealerships have enjoyed handsome markups on the cars they could get.
But what happens when we’re on the other side of this supply crunch? Most likely, selling prices will eventually fall back to a discount to MSRP and dealer margins will fall. The new car business is a prime example of how goods are about to become deflationary and of the potential squeeze on profits for certain players.
Inventory Surge Signals Price Declines
Downward price pressures are beginning to surface in the auto industry even though inventories are still low. Beyond the auto industry, broad measures of inventory levels point to another dynamic that may trigger deflation in other industries. In 2021, supply chain issues prompted a significant drawdown in wholesale and retail inventories (Display). But today, inventory levels have recovered to well beyond pre-pandemic levels, in areas from garden equipment to household appliances. And this reality is running headfirst into shifting consumer spending patterns.
For much of the past two years, consumers focused on buying goods because they were stuck at home. But today, the consumer is being pulled in two directions: necessities like food, gas, rent and utilities are seeing meaningful inflation, while the price of experiences such as vacations is also rising. So spending is increasingly focused on these two ends while demand for the “stuff” in the middle (i.e., goods) is falling sharply just as inventories are ballooning.
How Will Stocks Be Affected?
These trends in inventory and demand suggest that goods inflation should slow materially over the next year. While it’s difficult to make a definitive call on overall inflation—especially as the services component is larger than the goods side—we certainly see inflation easing. And if that happens, the Federal Reserve may be able to soften its aggressive interest-rate hikes. This, in turn, would help alleviate the pressure that we’ve seen on equity price/earnings multiples for most of this year, in our view.
That’s the good news for stocks. But on the flip side, we might see the profit margin profiles of companies diverge significantly.
Consider the US retail business as an example of some of the crosscurrents. Many retailers sold most of their merchandise at full price over the last two years. This pushed margins above historical levels and boosted sales levels. If we are headed into a sales slowdown, with discounting leading to lower margins, negative earnings revisions could become widespread.
While that scenario sounds dire, there are always winners to be found. For example, off-price retailers could be a potential beneficiary of this environment, as they get their best deals—and highest margins—when traditional retailers must offload excess merchandise. US retailing legend Mickey Drexler summed up the current environment well when he recently said, “I have never—but maybe I don’t remember—seen as much discounting with as much merchandise with high percents off.”
In this environment, investors in US equities must be increasingly selective and discriminating. We believe companies that benefit from secular growth trends and have quality management teams, strong pricing power and stable-to-increasing margins should be rewarded as business returns to pre-COVID norms. Meanwhile, investors should be cautious about businesses that experienced an unsustainable COVID tailwind; these effects could unwind in painful and unexpected ways.
Warren Buffett’s famous quote “It’s only when the tide goes out that you learn who has been swimming naked” neatly sums up our expectations for the second-quarter earnings season and the related second-half earnings guidance. Given what we are seeing, at least bathing suits will be on sale.
- James T. Tierney, Jr.
- Chief Investment Officer—Concentrated US Growth