Have you been surprised by the resilience of the U.S. consumer in the recent inflationary environment?

Kavitha Venkatraman: I would say I’m not completely surprised. The most common perception is that, because wage increases have not fully kept up with inflation, we would see a slowdown in consumer demand. In my view, consumer spending, especially on discretionary goods and services, is driven more by whether people are confident about keeping their jobs. The unusual confluence of a.) the strong U.S. job market and persistent labor shortages, b.) historically high household savings, and c.) excess cash available to U.S. consumers from lowering their mortgage payments and/or from recent wage increases goes a long way in explaining the resilience in consumer spending. That said, we are seeing pockets of demand weakness beginning to emerge, and household debt levels beginning to rise. The 2022 holiday season will be crucial in further shaping our view on the U.S. consumer.

Joe Hintz: As Kavitha mentioned, the consumer’s resilience has been less surprising given how well buffered household balance sheets were entering 2022. Personal savings rates as a percent of disposable income skyrocketed during the pandemic. People stayed in and spent less money as stimulus monies flowed into the economy, which meant that consumers were sitting on somewhere between $2 trillion and $2.5 trillion in excess savings exiting 2021. So even though personal savings rates are now at their lowest levels in about 15 years as consumers feel the pinch of rising costs, that savings account cushion has helped ease the burden.

What other factors are influencing your view of the consumer?

JH: On the Total Return team, we think that inflation could end up normalizing at a higher level than the market seems to be anticipating, which makes us concerned about whether resilience can be sustained across income brackets. We’re also watching wage increases, which are the stickiest form of inflation. The job market is not showing any signs of cooling outside isolated areas like tech. The job openings to unemployment ratio, for example, has barely moved lower this year. Consumers have also benefited from the disinflationary effects of globalization for several decades as production took place in specific geographies that enhanced economies of scale. We’re now seeing that trend reverse for several reasons, such as re-shoring, energy independence, etc. We see this story playing out across multiple industries, which in aggregate has the potential to keep inflation higher on a normalized basis than what the consumer has become accustomed to over the past decades as certain disinflationary forces unwind. I also think it’s important to look closely across consumers rather than look at the U.S. consumer holistically. For example, while in aggregate the U.S. consumer is still sitting on a significant chunk of excess savings, the lowest income quartile has already spent what remained of their excess savings built up during COVID, especially since products with the highest inflation rates this year (like food and energy) make up a disproportionate amount of spending in this income quartile. So those consumers who feel most constrained by inflation are already seeing the COVID savings boost deteriorate, and we think that will help drive consumer behavior in 2023 and beyond.

Can you talk about the long-term prospects for a particular consumer area?

KV: The first area that we on the Royce Small-Cap Opportunity team think offers opportunities for the long-term investor is automobile demand. Supply constraints caused by COVID-led factory shutdowns and the semiconductor shortage hampered global light vehicle production, which fell from 89 million units in 2019 to 77 million 2021 and is not expected to recover fully before 2024. Meanwhile, U.S. demand for cars continues to be strong, as evidenced by the lack of dealer inventory for both used and new cars and elevated car prices. There is an argument to be made for pent up demand benefiting the entire auto value chain even in a weak economy, driven by aging U.S. car parc.

Encouraged by this demand backdrop, we own several natural beneficiaries of the eventual recovery in supply. One is Asbury Automotive Group, one of the largest auto dealers in the U.S. While the market is rightly concerned about Asbury overearning due to historically high car prices, it is not giving enough credit in Asbury’s valuation for its improved market position, increased scale, and synergies from the sizeable acquisitions it made in 2020 and 2021. As new and used car supply normalizes, the full benefit of Asbury’s expanded scale and associated operating leverage should be demonstrated in much higher profitability compared to history.

JH: One way we are looking at the consumer space in the Small-Cap Quality Value Strategy that we use in Royce Small-Cap Total Return, while still maintaining our cautious view, is by seeking opportunities that benefit from some aspect of “trading down” during a recession or that have an idiosyncratic opportunity for fundamental improvements regardless of what may happen with the economy. For example, Franchise Group is a holding company with a handful of varied retail chains, including Vitamin Shoppe, American Freight, and Pet Supplies Plus. While Vitamin Shoppe and Pet Supplies Plus should prove resilient in a downturn, American Freight has the opportunity to actually expand due to this “trade down” concept. They sell furniture using a very basic, warehouse-style retail environment that helps provide strong value price points for their customers, which can obviously become more attractive if consumers begin to feel more of a pinch from inflation. This store concept has proven resilient in previous recessions and we think American Freight can benefit in a similar fashion during the next recession. We also like Denny’s, the famous 24-hour diner chain, especially its asset light business model of being predominantly franchised and that it leans heavily into the value-focused price points and could also benefit from a “trade down” as diners focus more on price. However, we also think it has the potential to revert to pre-COVID earnings levels. Denny’s historically had great unit economics because being open for 24 hours drove greater utilization of their fixed costs. However, tightness in labor availability has kept the company from returning to full 24-hour operations across the chain. As labor availability gradually improves, however, more stores will return to the 24-hour model, and earnings fundamentals should follow suit.

Can you discuss another area that looks attractive over the long run?

KV: The second area is housing and home remodeling. It’s widely acknowledged that there is significant unmet demand for housing in the U.S. today, caused by more than a decade of under-building after the Great Financial Crisis. Also, when we consider the degree of refinancing that occurred during the past couple of years to lock in historically low mortgage rates, it’s fair to posit that an existing homeowner is more likely to renovate than to upgrade to a better home. Against this supply-demand backdrop, it seems logical to expect that the outsized winners are likely to be home builders that have both finished homes as well as land parcels that can be developed and building products and services companies that cater to both homebuilders and remodelers. Royce Opportunity Fund has significant exposure to both cohorts in positions such as Skyline Champion, which makes manufactured and modular homes, park models, and modular buildings for the multi-family, hospitality, senior, and workforce housing sectors, and Taylor Morrison Home, which builds single-family detached and attached homes, as well as develops land to build lifestyle and master planned communities.

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