Beyond Bed and Bath

Good morning. On Sunday I had a good laugh at a New Yorker cartoon. It depicted a man watching the news. The talking head is saying: “On Wall Street today, news of lower interest rates sent the stock market up, but then the expectation that these rates would be inflationary sent the market down, until the realisation that lower rates might stimulate the sluggish economy pushed the market up, before it ultimately went down on fears that an overheated economy would lead to the reimposition of higher interest rates.” The cartoon neatly captures the inanity of the rates down/stocks up narrative that dominates most market discussions today. But what is really funny is that Bob Mankoff drew it in 1981. Do you think history repeats? Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Investing in retail

Bed Bath & Beyond declared bankruptcy over the weekend, and it plans to shut down all of its stores. The news was expected. The stock had been trading under $1 for over a month; it peaked at $80 a decade ago. What happened? To a first approximation, the internet happened. A pile-em-high-and-sell-em-cheap home goods store is very vulnerable to competition from Amazon. Looking more closely, there were strategic failures, most prominently expanding the store footprint, doing acquisitions and adding debt just as the online threat was picking up steam in the early- to mid-2010s.

The company’s store count and revenue peaked in 2018 but — and this is a familiar story in retail — profits had started to fall away years before as the competitive pressure ramped up. Here is a chart of revenue and free cash flow (operating cash flow less capital expenditure):

The standard advice to investors in retail is to look at economics on the store level; revenue growth driven by new stores is not sustainable if it is not backed up by improving or at least stable store-level performance — either in terms of same-store sales growth or profits. Here is the store count and free cash flow per store:

A particularly interesting wrinkle is that in its final years Bed Bath tried to reverse its declining profitability by focusing on higher margin own-brand products — a strategy that, in the abstract, made a lot of sense. But it turns out that customers wanted the brands, and that the company’s own-brand supply chain was not up to the pressures of the pandemic (The Wall Street Journal has a very good piece on this here.)

The Bed Bath story captures what is hard about investing in retail companies, especially legacy retailers who need to adjust their business models. The difference between success and failure depends on hitting the basic financial marks (don’t overexpand, limit leverage) but also on the niceties of retail strategy — on whether the companies know how to provide something that customers want. In this respect the interesting contrast to Bed Bath is the electronics retailer Best Buy. Best Buy’s products ought to be more vulnerable to internet competition than Bed Bath’s; people like to touch pillows and towels before buying them, at least. But Best Buy has remained quite profitable, using a strategy focusing on making sure both its salespeople and its suppliers are happy. Its shares are flattish over five years, but up strongly over 10. Here are revenue and free cash flow:

What are investors or short sellers to make of other beat up legacy retailers? Here is a financial comparison of some of the companies under the most pressure:

Best Buy and Dick’s, both of which sell products ripe for online competition, have a bit of growth in recent years (though Best Buy struggled in 2022 after a bonanza 2021), lowish debt and decent cash flow. The road ahead will be tough, but they will be around. Department store Kohl’s, with no growth, high debt, falling margins, little free cash flow and a stock down 60 per cent in 12 months, is clearly in desperate need of a turnround. GameStop, but for its meme-stock status, might be in the same boat. But Macy’s, Foot Locker and Nordstrom are trickier. Can they tweak their go-to-market strategy enough to secure the few percentage points of growth that are the difference between being a value stock and a liquidation play?

Sell USD, buy gold?

Gold prices are up 9 per cent since Silicon Valley Bank’s failed share sale, and up 22 per cent since November. Earlier in April prices came just shy of the all-time high, set in August 2020. Back then, the set-up was a classic bullish-gold story: geopolitical risk plus low rates. Today, however, something out of the ordinary is happening. From the FT’s Daria Mosolova:

Central bankers who manage trillions in foreign exchange reserves are loading up on gold as geopolitical tensions including the war in Ukraine force them to rethink their investment strategies.

An annual poll [by HSBC] of 83 central banks, which manage a combined $7tn in foreign exchange assets, found that more than two-thirds of respondents thought their peers would increase their gold holdings in 2023.

[Russia’s invasion of Ukraine] led the western alliance of the US, UK and EU to deploy extensive financial sanctions on Moscow, including measures to freeze around $300bn-worth of Russian central bank assets. The central bank’s gold reserves did not fall under the direct ambit of the sanctions as they were stockpiled in Russia.

Here’s the story’s key chart:

This fits how far gold has diverged from its key fundamental, prevailing real interest rates, which set the opportunity cost of yield-free gold. The chart below, the 10-year Tips yield against gold prices, illustrates the point. Gold is a good deal more expensive than real rates would suggest:

Elsewhere in the FT, Ruchir Sharma warns that gold has become “vehicle of central bank revolt against the dollar”:

Too confident in the indomitable dollar, the US saw sanctions as a cost-free way to fight Russia without risking troops. But it is paying the price in lost currency allegiances. Nations cutting deals to trade without the dollar now include old US allies such as the Philippines and Thailand .

The risk for America is that its overconfidence grows, fed by the “no alternative” story . . . The last line of defence for the dollar is the state of China, which is the only economy sufficiently large and centralised to challenge US currency supremacy — but even more deeply indebted and institutionally dysfunctional.

When a giant comes to rely on the weakness of rivals, it’s time to look hard in the mirror. When it faces challenges from a “barbaric relic” such as gold and new contenders like digital currency, it should [not take] its financial superpower status for granted.

Smarter people than us are debating the empirics of whether the dollar share of the $12tn in central bank reserves is, in fact, falling (see here and here). It certainly wouldn’t surprise if reserve compositions, controlled by governments, are sensitive to geopolitical risks.

But the dollar’s role in central bank reserves is just one component of dollar dominance, and arguably a smaller one. In forex, the world’s biggest financial market, the dollar played a part in 88 per cent of transactions in 2022, a share that is unchanged since 2019. 47 per cent of cross-border bank loans are denominated in dollars, according to the latest BIS data for September 2022. Private actors are responding to the real advantages of doing business in dollars, like deep capital markets and predictable courts. This, not currency allegiance, is at the root of dollar dominance.

One way to see this, adds FX veteran Karthik Sankaran, is in the fact that the currency composition of reserves looks a lot like the currency composition of global lending. Central banks can diversify on the margins, but if half your companies borrow in dollars, you need to hold dollars:

For all the focus on reserve share, I think the currency share of cross-border liabilities is more important. Reserve shares tend to mirror cross-border liability shares, but the scale of cross-border liabilities is a multiple of reserves [eg, $35tn in cross-border bank lending vs $5tn in non-dollar reserves], and the liabilities are also much more broadly held including vastly more in the private sector. Finally, the dollar’s global role is I think most pronounced in those periods where its use as a liability currency takes off — the Eurodollar market of the 1960s eg, with echoes of that also in the 1970s and in the 2002-2008 period.

Gold’s central bank-driven run-up is important, and interesting, but strikes us as too incremental to hurt the dollar much. If you think otherwise, let us know. (Ethan Wu)

One good read

A very big number.