Q3 2021
Kinsman Oak Investor Letter Q3 2021
October 19, 2021
MARKET COMMENTARY
Looking back, it appears speculative fervor peaked in the first quarter and has rolled over since then, although both sentiment and valuations remain elevated, in our view. We continue to monitor the Panic/Euphoria Model published by Citi Research which we referenced in our last quarterly letter (recently renamed the Levkovich Index). Sentiment, as measured by this indicator, remains below its all-time high but is still considered to be deep in euphoric territory (Appendix A).
Almost every popular meme stock and overly promotional SPAC trade far below their 52-week highs. Ark Innovation ETF (ARKK) net fund flows provide a decent barometer for gauging broad speculative appetite. Bloomberg estimates ARKK received net inflows of ~$8.3 billion from January 1st to April 15th of this year and had net outflows of ~$3.0 billion from April 16th to September 30th (Appendix B and C). Again, fund flows are still positive on a year-to-date basis, but fervor appears to be waning.
Inflation has been the topic du jour lately. Yields continue to be the fulcrum driving factor rotations. At the risk of sounding like a broken record, single stock volatility remains elevated for this reason, despite the appearance of a rather smooth ascension to new highs for most indexes. Investors are beginning to turn their attention to what rising costs and component shortages could mean for upcoming earnings and forward guidance. Tailwinds are turning into potential headwinds, especially if the pace of fiscal stimulus slows or central bank liquidity is withdrawn.
INFLATION MORE ‘TRANSITORY’ THAN EXPECTED
Six months ago, we discussed our belief that secular inflation was premature to conclude based on the available information at the time. Today we find ourselves closely re-examining our thoughts on the subject. We seldom agree with central banks in general, so sharing their view that inflation was transitory felt unusual. Here we are six months later, and inflationary pressures persist with little signs of abatement.
Input cost inflation, component shortages, and labour issues present a real risk to revenue and earnings expectations going forward. Sustained inflation will persist as cost structures continue rising, and logistical nightmares wreak havoc on global supply chains. The labour market remains a complete mess. It is difficult to envision how these issues will meaningfully alleviate anytime soon. Rising inflation combined with lower economic growth suggests potential stagflation.
We continue to believe longer-term structural disinflationary pressures will eventually reassert themselves. Low economic growth, hyper-financialization of the economy, excessive debt levels, financial repression, gargantuan unfunded liabilities, and severe demographic challenges have all intensified. But the path from today to long-term, or the duration of time between those two points, is much less clear.
Real Real Interest Rates Deeply Negative
Official CPI metrics for September were +5.4% y/y while the yield on the U.S. 10 year was +1.57%, meaning real interest rates are -3.83%. People can endlessly debate the exact accuracy of CPI metrics, but it is clear, given substitution effects and hedonic adjustments, official headline numbers are vastly understated. Further obfuscation comes from the OER (Owner’s Equivalent Rent) component of these calculations which, in our view, has become farcical and in no way reflects reality.
As such, we believe ‘re-normalizing’ the data to better reflect actual rising price levels would result in higher true CPI metrics, although it’s impossible to quantify by precisely how much. The same way Warren Buffett doesn’t need to know the exact weight of a 350-pound man to know he’s fat, we don’t need to know exactly how much higher true inflation is to know that real real rates are more negative than meets the eye. At current yields, U.S. Treasuries are essentially trading sardines used for collateral purposes.
Severe Supply Chains Issues Are Getting Worse
Supply chain issues pose a material risk to revenue, earnings, and forward guidance expectations. Describing these issues as unprecedented feels like a gross understatement. Supply/demand dynamics have arguably never experienced such a severe and abrupt dislocation. The pandemic put immediate constraints on the supply of goods and services while a flood of direct fiscal stimulus increased the demand for said goods and services. Besides inflation, the obvious consequences from this staggering mismatch were product shortages and dysfunctional supply chains.
Admittedly, we underestimated the amount of time it would take for supply chains to renormalize. It’s important to remember what these complex networks looked like pre-pandemic. They were designed in a way that maximized efficiency at the expense of robustness. There was no slack built into these systems, making them extremely fragile to external shocks. A grain of sand entering a fine-tuned engine could grind it to a halt. This pandemic was basically ripping the engine out of the machine entirely and tossing it into the desert. As if that wasn’t bad enough, the pandemic caused changes in global consumption patterns as well. Repurposing these complex networks to accommodate new preferences requires time and capital.
Sourcing metal shipping containers is difficult and, even if your business can pay nosebleed prices to find some, port availability becomes your next major hurdle. Anchoring a large ship in the ocean to wait for empty loading dock space is expensive. If those ships are transporting critical components, the delay could cause serious bottlenecks in a much larger manufacturing process. For instance, even Apple recently announced production cuts due to chip shortages. On one hand, we believe the logistical nightmares are temporary. On the other, we wonder if implementing a permanent solution, such as increased redundancy and capacity, will result in higher structural logistics costs going forward.
Inflation Rolls Downhill
Input cost inflation takes time to flow from those at the beginning of the supply chain (Point A) to the end consumer (Point Z). Generally, intermediaries between Point A and Point Z are inclined to absorb initial price hikes from their supplies, keep prices flat for their own customers, and accept temporary margin degradation to drive improved retention. But, as time passes, these intermediaries will begin to pass more of those incremental costs down the chain to their customers, who then pass it along to their own customers, and so forth. Eventually, the end consumer is paying higher prices, but there can be a lengthy delay from when those at the beginning of the supply chain hike prices and those at the end experience them.
We highly recommend reading the Lamb Weston (LW) and Bed Bath and Beyond (BBBY) earnings call transcripts to get a deeper understanding of how broad based these inflationary pressures are. Lamb Weston, specifically, mentions how their input costs have skyrocketed but the company has only passed a portion of that increase onto their end customers. As such, the company plans to implement a series of price hikes over the next several quarters to compensate for that. Clearly, cost inflation is rolling downhill, albeit slowly. This suggests end consumer inflation will continue to persist over the intermediate time frame as these pricing pressures roll all the way down hill.
Further, rising prices do not typically occur in a vacuum. They are generally accompanied by longer lead times, widespread product unavailability, and empty shelves. It’s worth noting there are no upward adjustments to CPI figures for longer lead times or product availability either. We wonder if there may be a possible inventory overhang once supply chain issues dissipate. It is possible businesses are over-ordering products from their suppliers, assuming they will only get a small percentage of whatever they ask for. Empty inventory channels today could potentially precede bloated inventory channels down the road.
Labour Market Oddities
Labour market conditions have gone from unusual to completely bizarre. Job openings in the U.S. reportedly fell from a record of 10.9 million to 10.4 million and the unemployment rate is falling. At the same time, it’s also been reported that a record 4.3 million workers recently quit their jobs (Appendix D). Many believe labour shortages are driving supply chain issues but none of the explanations for why these shortages exist in the first place seem to adequately justify the magnitude of how bad these problems are.
Companies we follow have made numerous references on recent earnings calls about higher wages weighing on cost structures and cite major employee retention difficulties. Whatever the underlying causes may be, it’s obvious the clearing rate of pay for most jobs keeps climbing. The word unprecedented is thrown around way too often lately but these labour market oddities are truly confounding. Widespread labour shortages combined with worsening supply chain issues are deep economic problems that cannot be solved overnight. Both of which will likely exacerbate broad inflationary pressures for quite some time.
LOOKING AHEAD
Investor sentiment is off peaks but remains way higher than historical averages. Valuations are considered extreme by every conceivable metric and economic growth is decelerating. Economists are beginning to cut GDP forecasts and nominal yields continue rising. Inflationary pressures exacerbated by logistical nightmares and labour market challenges could potentially threaten earnings. We continue to see opportunity on both the long and short sides of the portfolio, but will exercise more caution and tighter risk controls as we attempt to generate returns.
Sincerely,
