Fundamental Credit: What’s in Focus

Guy: Brian, I believe that it’s best to review where markets have been, in order to get a sense of where they are going …. and discuss how PM’s might adapt accordingly as the landscape changes and think about what may or may not be priced-in

Today, given the rise in inflation and central banks transition away from 14 years of extraordinary monetary accommodation, I think this is a good place to start. With that as the backdrop, could you provide a quick summary of market behavior during this decade of easy money – I believe those market impacts and investor psychology is worthy to mention.

Brian: It is a widely accepted premise that easy monetary policy has lifted risk assets, narrowed credit spreads and created a “buy the dip” mentality for an entire generation of investors. Returns of financial assets for the past decade have been well above historical returns. For traditional long investors, including credit investors, there hasn’t been a ‘right or wrong” there has only been degrees of “right”.

Guy: Let’s continue to keep it at a high level for the moment. As central banks shift direction, what do you believe that means going forward?

Brian: Extraordinary policy accommodation means that outsized returns in recent years were in a sense borrowed from the future, and so investors should expect lower annual return going forward. It means that the returns generated merely from chasing risk and chasing yields will not necessarily work out as well. I believe there are still reasonable returns to be made but that they will need to be better derived from careful security selection. Going forward, I expect active and discretionary managers to outperform.

Guy: I agree with you there. The borrowing of returns from the future, I refer to as “time inconsistency”, whereby for the past decade central banks have overly focused on making “today” but doing so with a lack of regard for unintended consequences of“tomorrow”. The new paradigm of tighter policy will be more challenging but should, as you say, benefit active and discretionary managers.

Could you elaborate on why now is a better time for active over passive? And maybe, you could you elaborate by providing some detail around what you and your team are doing?

Brian: We believe 2021 was a year of massive credit repair for almost every sector - absent those however who got hit hardest by the pandemic, such as gaming, lodging, leisure, airlines.

In 2022, we are looking closely at how companies will make use of their free cash flow in 2022 and beyond. In a non-accommodative monetary paradigm along with fiscal stimulus in the rearview mirror, we are laser-focused on how companies plan to create value for shareholders, particularly with high valuation multiples. Opportunities for Alpha will come from such analysis, helping to pick winners.

Guy: I assume that many of those metrics are somewhat different than they used to be because the pandemic has significantly changed consumer behavior…. and how workers work, and certainly has impacted supply chains, and the basic composition and characteristics of goods and services. With that in mind, is it fair to say that the way you conduct analysis has adapted as well?

Brian: Absolutely, it has. Gross margins are compressing across the board, particularly for consumer staple companies. The level of compression is significant, ranging from 300 bps to over 1200 bps, depending on the company.

Now, the sources of the gross margin pressures have come from a range of areas, such as:

• Higher commodity and packaging costso Higher freight and transportation costs (reflected in part a lack of truckers which was present even before the omicron outbreak, and then exacerbated by the omicron outbreak and recent protests over mask mandates).
• And higher manufacturing costs - which is also a function of constrained labor availability.
•  Most companies experienced cost inflation on all four of these inputs.
  

Guy: And I assume, these companies are passing their cost increases along to the consumer, where they can, which is one of the factors further fueling inflationary pressures?

Brian: Companies have certainly been raising prices, however those increases are only a fraction of the cost increases hitting businesses.· So the bottom line is that, while companies were passing along some of their higher costs to the consumer it has only been a small portion.

Going forward, we do have some hesitation on this issue as we step back and take a look at consumer goods inventory levels relative to pre-pandemic trends. Consumers are clearly under pressure in 2023 as real disposable personal income has declined from the artificially inflated levels as transfer payments have rolled off.

In addition, wages are not keeping up with inflation implying consumers will be converting a higher percentage towards inelastic spend like food and energy. This is occurring as goods supply, excluding autos, is now well above pre pandemic trend in real terms.

Pulling this together, we are less than optimistic that companies in the durable and non-durable consumer space will be able to fully achieve price hikes to offset cost pressures at this stage.

Guy: How is that decision made? Meaning, what are the factors that determines a company’s ability to passing along input costs to the consumer?

Brian: There are several determinates.

The first deals with a company’s market share as well as what their competitors are doing. Pricing followers generally wait for the industry pricing leader to move first.

Then there is Retailer Pushback. Practically speaking, large big box retailers and warehouse clubs will not accept immediate price increases. Vendors typically need to give their large customers two to three months notice, that a price increase will go into effect.

Then there is there is the presence or lack of presence of private label: is private label an important player in the subsegment? Are retailers raising their private label prices or using this as an opportunity to grow market share for their private label products? The answer will depend on the specific product as well as the retailer’s objectives for its private label program.

And there is also Vendor performance. Vendors which are missing shipment deadlines or having trouble filling orders find it very hard to raise prices to their retail.

Guy: That is an excellent place to wrap up today. Thank you, Brian, for sharing your insights.

Brian: Thank you.

_{ⁱ As of December 31, 2021}

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