Good Afternoon Income Investors!
"Higher for longer" is officially the new "inflation is transient" chant. The market is growing to believe that interest rates won't be cut until June at the earliest. The impact on stock prices has been a lot more muted than we've seen to changing predictions over the past few years. Instead of manifesting as broad sell-offs, it has served more as a restraint on a rally among Value stocks. Interest rate sensitive stocks haven't sold off, but they also haven't been strong participants in the market rally.
Today, I want to look at what is to blame for "sticky" inflation, and some potential catalysts that could cause deflation which would really surprise the market.
Remember, the purpose of raising interest rates is to cool off consumer demand. It works when inflation is being driven by consumers who have excess spending power and are driving inflation with demand that is higher than the production system can keep up with. You raise interest rates, which reduces the buying power for consumers and discourages them from making purchases. This allows businesses to catch up, and be able to produce enough to meet demand and moderates upward pressure on prices.
Is the consumer really strong? Is the economy really hot? Are businesses really struggling to keep up with all the excess demand? I'd say no, and I'd wager that I could ask random people on the street, and they would also say "no" if they could stop laughing at the ridiculous questions long enough to speak.
Core PCE – "Sticky" because of Consumers?
Another month, more of the same headlines. Core PCE is "sticky", and inflation is staying higher longer than expected. Mary Daly, President of the Federal Reserve Bank of San Francisco, blamed consumers, saying to Bloomberg that the resilient consumer
"kept inflation a little bit higher for longer than we would have thought."
Really? Here is what the consumer has been doing:
See that number? It's negative. Know what that means? It means consumers are buying fewer things. This is the first time in history that real retail sales have been negative for this long and we weren't in a recession.
Additionally, since 2022, consumers have been funding a very large portion of their purchases on credit cards. Credit card debt has grown at the fastest pace we have seen in over 20 years.
The consumer isn't driving inflation. They are buying fewer things at higher prices and borrowing to do it. Additionally, an increasing number of these borrowers are becoming delinquent. The credit card delinquency rate blew right past pre-COVID levels.
However, it is worth noting that delinquency rates are still below the 4%-5%ish level that was "normal" before the GFC. So we aren't looking at recession-level delinquency rates yet.
What is Driving Inflation?
Housing is driving the inflation metrics.
Core PCE excluding housing is at 2.15% YoY and has been on a steady decline. Source
When you look at housing on its own, you can see that it remains extremely high. Source
I don't think you need to be a real estate expert to know whether the real estate market was hotter in 2020/2021 or today. Yet, according to PCE inflation data, the housing market is hotter right now than it was throughout 2020 and 2021. This is because inflation is inherently a backward-looking metric, and housing inflation is particularly delayed. It is delayed by about 18 months. So, January's housing inflation in the PCE report tells us what housing inflation was around July 2022.
The Fed has already done what is needed to reduce inflation. Raising interest rates works by reducing demand. The Fed has utterly decimated demand in the housing market. It is at GFC levels.
The Fed can hike interest rates as much as it wants, it obviously isn't going to impact home prices – the biggest contributor to current inflation metrics.
Retail Sales: What Are People Buying
When we look at the details of retail sales, overall, they rose 4.45% in 2023, but there is a wide disparity in which types of stores saw an increase in sales. I'd wager that a good number of you can predict which types of stores were above-average.
Food Services & Drinking 10.9%
Health and Personal Care 8.8%
Non-store retailers (mostly online) 6.8%
Motor Vehicles and Parts 6.4%
Every other category was below average (and below inflation).
What does this tell us about the consumer? The spending that they are increasing, is primarily spending on what most of us would call essentials. Food, cars, health, and personal care products. Plus, it is a continuation of a long-term trend for online retailers gaining market share.
Manufacturers: Cutting Back
I've discussed the ISM PMI (Purchasing Managers Index) numerous times in the past few years with our HDI members, and one of the things I've said about it is that manufacturers had an enormous backlog of orders, which was supporting employment even as new orders slowed down. As a result, the weakness of the manufacturing sector wasn't spreading into the rest of the economy.
I noted that eventually, manufacturers would catch up and become reliant on new demand, and that is when real cuts would start to happen. Source
Institute For Supply Management - Feb. 2024
Manufacturing PMI has been below 50 and in contraction for 16 months now. The backlog of orders has been falling for 17 months and for the past 5 months that has been manifesting with lower employment.
These are very volatile numbers, but the length of the slowdown clearly illustrates a reduction in demand that is now starting to impact employment. There is one time since 2000 that an ISM employment reading this low was not followed by a recession, and that was 2016.
The Employment Situation report is coming out on Friday, so we will see if that mirrors any of the weaknesses being seen in the manufacturing space.
Putting the Pieces Together
So we have core PCE inflation that is approaching 2% when we exclude housing, and consumers are spending more money but buying fewer things. The types of stores that are seeing the largest increase in consumer spending are related to "essentials", and consumers are increasingly reliant on using credit cards to fund these purchases. Credit cards where they are paying the highest interest rates they have paid in 20 years and delinquency rates are the highest they've been since the GFC.
Does that paint a picture of economic strength or economic weakness to you? Does this sound like a "thriving" economy on a strong foundation that needs to be restrained by high interest rates to avoid running too hot?
The U.S. economy is one bad catalyst away from being pushed into recession.
A Potential Catalyst: China
Outside of the U.S., China is experiencing deflation and could return to "exporting deflation".
In recent years, the Chinese government has attempted to shift the economy towards domestic consumption, but the Chinese consumer has been reluctant to spend on credit. As a result, the government invested in housing and infrastructure to absorb the excess production capacity. With deflation setting in, there is speculation that China is now pivoting back towards manufacturing and massive exports to sustain growth.
The most likely scenario is that China will shift its focus from domestic infrastructure and housing to manufacturing, with a specific focus on EV's, batteries, and renewable energy products. This shift may lead to protectionist opposition and friction with their raw material processing activities. Yet, the overall effect is likely to be deflationary, with evidence of deflation already in China.
While growth is slowing down, predictions of a total collapse of the Chinese economy or a banking catastrophe are unlikely to come to pass as the Chinese government exercises a much greater level of control than Western Central Banks. As a general matter, growth in China is likely to slow, and the push to export to make up for it would drive down product prices around the world. Imports of raw materials in China may not increase – largely because the reduced investment in housing construction and infrastructure will offset increased manufacturing. In fact, there may be a long-term downturn in imports of certain products that were heavily used in the construction sector.
The overall effect is likely to be deflationary and there is evidence of deflation already in China. For many years, China had a generally deflationary impact on the U.S. economy. Since COVID, that impact has diminished, but it is likely to return again.
We don't have any direct exposure to Chinese investments in our portfolio, and we intend to keep it that way.
Conclusion
The Federal Reserve appears positioned to keep rates "higher for longer", and if I were a gambling man, I would bet that they do. In my opinion, the Federal Reserve has already made what will be judged in hindsight as a "policy error". Yet, it is a policy error that they are doubling down on. Shelter is going to continue having an overwhelming impact on the inflation metrics and keeping them above 2% for the next few months.
As income investors, this is good news for us. It gives us a longer period to focus on buying up high-yielding investments while there are plenty of options. It also provides us time to continue building our fixed-income portfolios so that when there is a recession, we can be confident that our income will continue coming in. I suggest you continue to favor fixed-income and avoid getting too greedy.
A common mistake among high-yield investors is that they get tempted into over-allocating their portfolio with the highest-yielding holdings. Make sure you have some of the lower-yielders mixed into your portfolio. A healthy balance of defensive dividend payers is necessary to navigate through any environment. At HDO, we have several picks with below 7% yields, from stable companies that provide much-needed defensiveness and income reliability.
Pick 1: Realty Income - Yield 5.9%
Realty Income (O) is the 5th largest global REIT with an extensive portfolio of 13,458 properties leased to 1,326 clients across 86 industries. 40% of O’s total property rent is drawn from investment-grade tenants, and the REIT’s portfolio has a weighted average remaining lease term of ~9.8 years. The REIT maintains adequate liquidity for opportunistic acquisitions to grow amidst depressed industry valuations. O is a phenomenal dividend-steward, having raised its dividends annually for 29 consecutive years. Its current $0.2565/share monthly dividend calculates to a modest 5.9% yield.
Pick 2: Verizon - Yield 6.7%
Verizon (VZ) is the largest U.S. telecom company by FY 2023 revenues, with impressive customer retention and additions to its premium plans despite raising prices through the fiscal year. The telecom leader has raised dividends annually for 17 years (check this number), and its current $0.665/share quarterly payment calculates to a 6.7% yield. VZ’s FCF and adj. EBITDA guidance for FY 2024 indicates solid room for another healthy raise this year.
Pick 3: Antero Midstream - Yield 6.6%
Antero Midstream (AM) operates and develops midstream energy assets to primarily serve Antero Resources (AR) and has fee-based contractual agreements in place until 2038. Since the global pandemic, AM has been prioritizing FCF growth, and is in an impressive position to reduce debt, buy back shares, and maintain its dividend at a 60% payout ratio. The company's recent $500 million shares buyback program demonstrates commitment to delivering returns to shareholders.
The HDO Model Portfolio is curated with the intent of being well-balanced to provide a sustainable yield averaging 8-10% regardless of economic conditions. Make sure you are balancing your portfolio, taking advantage of some of the more conservative DGR type investments that are providing a better starting yield than they have historically. I hold every ticker in the HDO Model Portfolio, and I believe that diversification is the best way to execute the Income Method.
Stay focused on your income, and make sure you can keep increasing it. In a recession, cash flow is king.
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