by William Smead, Smead Capital Management
Dear fellow investors,
Two major labor unions, the Dock Workers Union and the Boeing Machinists Union, have attempted to reach an agreement with their employers on a contract. The dock workers agreement proposes an average 8.5% per year wage increase over six years, and the Boeing Machinists Unionâs proposal is for an average 7.5% wage increase over four years. The dock workers will get paid 62% more in six years than today, and, if ratified by their members, the machinists will get 35% more in four years.
If the Federal Reserve Board is successful in using monetary policy to keep inflation in the 2-3% area over the long run, why do these powerful unions need and get such large increases? Secondly, how much of a factor in the inflation rate will they have both absolutely and psychologically? And what does this mean for the equity markets and price-to-earnings (P/E) ratios going forward?
These unions are near and dear to my personal history. My father was a Columbia River ship pilot and president of his local pilot association. My Dad interacted with the dock workers every week and felt that they were overpaid for what they did back then. My middle son is a machinist with a Boeing subcontractor at Paine Field in Everett, and he interacts with their machinists every week.
This leads us to look at the definition of cost-push inflation:
Cost-push inflation occurs when the total supply of goods and services in the economy which can be produced (aggregate supply) falls. A fall in aggregate supply is often caused by an increase in the cost of production. If aggregate supply falls but aggregate demand remains unchanged, there is upward pressure on prices and inflation â that is, inflation is âpushedâ higher.
These two powerful unions are going to âincrease the cost of productionâ of airplanes in the case of Boeing and increase the cost of imported and exported goods sent or received at the docks in America. To understand the effect of their actions, you can look first at what it says about their opinion of the future success of the Federal Reserve Board in controlling inflation as the Federal Government runs massive budget deficits. Also, it says quite a bit about the massive size of Federal Government debt relative to GDP. IT SAYS THAT THE UNION DOESNâT THINK THERE IS ANY CHANCE that a 4% per year increase would defend their rank-and-file memberâs purchasing power!
This is likely to ripple through other powerful unions and companies threatened by an effort to unionize, like Starbucks and Amazon. It means a strong psychological undergirding of what they need to do in an inflationary environment. To us, it just adds to the comparison of what the 1970s looked like as we seek the rhyme of the most likely outcomes.
Letâs shift gears and look at what higher-than-anticipated inflation could mean for the performance of todayâs most popular investment vehicle, the S&P 500 Index, in its various forms:
The above chart shows that investors typically prefer a guaranteed rate if it is competitive with expected future returns in equities. In the aftermath of the Fed cutting interest rates recently, the 10-year Treasury bond has seen net selling that drove its yield higher. As the yield increases, the stock market has traditionally taken P/E ratios lower. When bond interest is able to pull money away from stocks, investors are more inclined to accept guaranteed interest in lieu of higher and more variable returns. We know what that looks like because I spent my first 20 years in the investment business helping people gain the most advantage out of long-term guaranteed interest rates of 8-15% from 1981-1994.
Therefore, we are attempting to own common stocks that we believe can best navigate a contracting P/E environment. We own several companies that history shows performed well in the last cost-push inflationary environment and/or in some way may benefit from the inflation zeitgeist. This zeitgeist, which could develop like the one that existed in the 1970s, is what these powerful unions are attempting to defend their members from.
Fear stock market failure,
William Smead
The information contained in this missive represents Smead Capital Managementâs opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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