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March 1, 2024

Assessing “greedflation”

As we noted in our Investing for Inflation Protection guide, inflation remains one of the most poorly understood subjects in economics. There is some general agreement about its causes, such as printing a lot of money or shrinking productive capacity. But much of it remains a “mystery,” as then Fed Chair Janet Yellen said when she expressed confusion over persistently low rates of inflation in 2017.

Janet Yellen

If a former Fed Chair and current Treasury Secretary isn’t confident about how inflation works, the average citizen is unlikely to have well-formed or high conviction views on the subject. Against this backdrop, the Biden administration has been floating some new economic concepts for public consumption.

But for all we’ve done to bring prices down, there are still too many corporations in America ripping people off:  price gouging, junk fees, greedflation, shrinkflation.  - President Joe Biden (1/27/2024)

If this sounds like blame-shifting, one can understand why they are doing it. Biden’s approval ratings are at extraordinarily low levels, driven by a perception of very poor economic performance.

The public’s appraisal of Biden as an economic manager presumably has little to do with the stock market, with the S&P 500 back to all-time highs. Unemployment rates are also quite low by historical standards. As of January 2024, the unemployment rate stood at 3.7%, which is well below the 20-year average of 5.9%. It is also just a bit higher than the lowest level that was achieved during the Trump administration of 3.5%.

Inflation is of course the reason the public feels so bad about economic conditions. According to Gallup, the average American’s sense of his or her own purchasing power is at a generational low.

Despite having subsided considerably, with January CPI coming in at 3.1%, inflation rates remain above Fed target levels of 2%. But the real story is the cumulative effect of inflation over the past three years, which comes in at 18%. This represents a historic decline in the purchasing power of a dollar.

Source: Bureau of Labor Statistics

One interesting characteristic of inflation versus unemployment as a driver of perceptions of economic well-being is that inflation affects all consumers. By contrast, a shift in the unemployment rate may severely affect only a few percentage points of the population, while leaving the vast majority of workers relatively unscathed.

It may be difficult for an employed worker to find a new and better job when unemployment rates are high, but at least inflation is usually not soaring when this happens. The typical correlation between high unemployment (e.g., a recession scenario) and low inflation benefits employed individuals from a buying power perspective.

For example, in 2009, during the financial crisis, we actually saw meaningful deflation, with CPI coming in at -2.1% in July of that year. A gainfully employed civil servant with a steady paycheck might have been worried at the time about his 401k or the plunging value of his home, but from the standpoint of income and expenses, he was doing okay.

Nowadays, almost everyone is losing sleep. A recent study by the American Psychological Association points out that some 83% of Americans feel inflation is a “source of stress.” The Biden administration therefore has every reason to try to redirect public resentment. “Corporate greed” is as good a target as any.

Is greedflation misinformation?

While there is some evidence the corporate greed narrative is already having its intended effect on voters, is it backed by data?

An important element of this narrative is that America’s retailers have been gouging their customers. This prompted us to take a look at the income statements of the biggest U.S. retailers over the past 3 years, when cumulative inflation approached 20%.

If stores were aggressively marking up merchandise, one would expect to see this reflected in higher gross margins.

Gross margins are a more direct potential indicator of price gouging than operating margins or overall profit margins, because they reflect the difference between sales (money collected from customers) and the cost of goods sold (wholesale costs and other costs directly connected to stocking goods).

We actually observed the opposite trend. Over the three-year period of high inflation, gross margins declined at 9 out of the 10 large retailers. On average, gross margins declined by 1.3%.

As a second check on the “greedflation” hypothesis, we looked at the performance of the retail sector over the course of the same three-year period. Specifically, we measured the performance of SPDR S&P Retail ETF (XRT), an equal-weighted ETF that tracks the U.S. retail sector, relative to the S&P 500. XRT represents approximately 75 retail stocks.

One might assume that if the retail sector were collectively exploiting consumers and earning excess profits by jacking up prices, retail stocks would have performed exceedingly well as inflation took hold. In reality, retail stocks (as measured by this ETF) underperformed the S&P 500 by about 15% and delivered a total return that was approximately equivalent to cumulative inflation over the three-year period.

Investors in U.S. retailers basically earned a real return of zero as inflation soared, which seems inconsistent with the idea of illicit profiteering.

Source: FactSet

While it is easy to scapegoat greedy businessmen for policy failures, the reality of the American consumer economy is that it is extremely sophisticated and intensely competitive. Barriers to entry in retail are low, and e-commerce continues to take share from traditional brick and mortar and grow at double digit rates.

Consumers are remarkably savvy about getting the best deals they can find, in the physical world or online, especially now. America’s retailers understand that this is exactly the environment in which you build loyalty by delivering the value for money their customers so desperately need.

We like providing extreme value. - Richard A. Galanti, Chief Financial Officer, Costco (Q1 2024 earnings call)

If only our government were as forward-thinking, efficiently operated, and attentive to the needs and preferences of its customer base as companies like Costco (COST).

Now, there are a number of competitively advantaged businesses across industry sectors that have consistently displayed an ability to raise prices ahead of inflation rates. (In fact, we target these firms across all of our Model Portfolio strategies. Pricing power is among the hallmarks of a strong business.) Additionally, well-managed retailers are generally able to pass through inflation and sustain their profitability in real terms.

Instead of attributing the inflationary wave of the past three years to predatory corporate executives, one might rather consider factors like unprecedented money supply growth, foreign policy errors leading to global supply chain disruptions, domestic policy decisions leading to capacity constraints and excessive fiscal stimulus. The greedflation talking point can justifiably be described using another preferred term of the current President… malarkey.  

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