Eating Out Is Expensive

The Days Ahead:

• Earnings reports kick into gear.

This Week:

• Most inflation is coming down.
• But not restaurants or the “Eating Away From Home” category
• Running a restaurant is like a microcosm of the economy
• But workers are hard to find.
• European defense spending gets serious.
• It’s been a good time to own stocks in European defense companies.
• Can they keep it up?
• Another record for the S&P 500. Markets don’t look at politics.

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Eating Out

There’s a reason the Fed prefers “core” inflation, which removes food and energy from inflation readings. When oil and gasoline prices move, there’s really nothing that the Fed can do with interest rates to change anything. Energy prices are only tenuously tied to rates or the cost of capital. Usually, they’re a result of global decisions at OPEC and oil trades around the world at the same price, with regional differences in quality or purity.

Food is the same. If prices for staples like grain and wheat rise, raising rates will have little effect on demand and no short-term effect on prices. Most consumers substitute food items if costs rise, or new supply comes online. The Fed remains on the sideline.

Together food and energy make up 21% of the CPI index. Both are, in economic speak, price-inelastic. If I need to drive to work or feed the family, I may not like the prices, but my demand will stay the same. I’ll save elsewhere. There are exceptions of course. If gasoline goes to $15 and stays there, then I might start to take the bus, buy a bicycle or move closer to work. But in general, the Fed can’t build sensible monetary policy around short-term moves in food and gas prices.

But there’s one category of food that is discretionary and where rates and monetary policy can make a difference. It’s “Food Away from Home.” It’s 5.3% of the CPI and 25% of the Food and Energy Sector. It includes food that you pay for and eat outside your home, such as cafeterias, vending machines or street sellers. It also includes “Full-Service Meals” where you sit down, order and eat all at the same time. It’s 2.4% of the total index and 11% of the Food and Energy Sector and 7% of the PCE, the Fed’s favorite inflation measure

As others have noted, Food Away from Home, or restaurants, is a microcosm of the economy. There are costs for wages, food, transportation for delivery, rents, taxes, capital equipment and energy for ovens, fridges, fryers and ventilation. There’s around $150,000 to $400,000 of kit in a full service restaurant ranging from a $220,000 La Cornue stove to a $25,000 exhaust system.

Wages are a problem. Many restaurant staff are exempt from the federal minimum wage of $7.25 an hour, which was last increased in 2010. It gets more complicated at the state level, where minimum wages range from 12 states at the Federal minimum of $7.25 to California’s $16.00. However, that excludes staff who receive tips, where the minimum is $2.13.

Covid-19 hit employment in food services hard. There were more people working in the industry in 2019 than there are now. Employment dropped from 12.31 million to 6.3 million and has gradually hauled its way back to 12.30 million now. Wages and salaries for all workers rose 18% from pre-Covid-19 to April but rose 26% for food workers. The industry hasn’t been able to attract enough people and must pay higher wages, which raises operating expenses.

So, it costs more to eat away from home.

The amount spent at restaurants is running at $94 billion (blue line) a month or 13% of all retail spending (green line.) Spending runs at a record high but the trend of restaurant spending as percent of all spending is no higher than it was in 2020.

Restaurant spending at $94 billion surpassed that of eating at home at $82 billion in 2021. Since then, food spending at home rose 4.5% and restaurant spending rose 18%.

Put that all together and we see both increased wages for hard-to-find labor and consumer demand up. That’s a recipe for inflation. Here’s the annual average price increase for restaurants.

Prices are up 4.1% over the year, running at 4.6% for the last three months and 5.1% for the last month. Before Covid-19, prices rose 2% to 3% a year.

It could be that restaurant prices won’t ease much. Fewer people are choosing to eat out but prices have risen. Labor costs are unlikely to fall. The work is often part time, with unsocial hours and few benefits. The BLS puts the average yearly wage at $29,710. Yes, many workers carry two jobs, but it’s half the average annual wage. It’s also hard to keep staff. There are 12.3 million employed in the restaurant industry but 1.1 million openings. Average staff turnover is 108% a year.

The recent price acceleration may be noise. After all, inflation is easing in about every other category. It’s also a volatile series. But restaurants are a classic discretionary spend and remain expensive with no sign of price easing. In a slowing economy, they could be vulnerable.

European Defense Spending

Since Russia’s invasion of Ukraine two clear issues have risen about European defense spending: it wasn’t enough and military supplies were in short supply. The quality and technology of arms has never been an issue. A U.K./French Storm Shadow missile can deliver as big a punch as Lockheed Martin’s ATACMS, and both are valued battlefield weapons. The German Leopard 2 or the U.K.’s Challenger 2 tank are a match for the U.S. Abrams M1. The German IRIS-T air defense system is very much on a par with the better-known U.S. Patriot missile system.

But they’re all in short supply.

The problem with defense spending goes back to 2006 when there was a NATO commitment to raise defense spending to 2% of GDP. NATO includes 30 out of 44 European countries with only historically neutral countries like Austria, Switzerland and Ireland or small countries like Andorra, Cyprus or Lichtenstein excluded.

The 2% goal is far from complete.

Only eight countries meet the 2% goal. Countries like Estonia and Lithuania have exceeded the target, but the absolute amounts are small. For Estonia it’s $800 million and Lithuania it’s $1,800 million. Together that’s less than one day of U.S. defense spending at $916 billion.

NATO is not financed separately. There are no divisions or weapons dedicated to NATO. Each country commits to a level of defense spending and is expected to contribute to NATO should the organization commence any joint action under the famous Article 5, which states that an attack against one member requires a response from all members. It was invoked once in 2001 after the 9/11 attacks.

European defense spending faces three problems.

One, it delivers little reliable combat power. NATO countries are meant to spend on three categories of defense: 1) personnel, 2) development and procurement and 3) maintenance and operations, with 20% committed to development. Instead, it spends disproportionally on the other two. Around 61% of Italy’s defense budget, for example, is spent on personnel. For the EU it’s at 44%. In the U.S. it’s 24%, despite U.S. military pay being 40% higher than the EU.

Germany will spend €52 billion on defense spending in 2024, lower in real dollars than 1987, and perhaps only €0.5 billion for procurement.

Two, it lacks long-term command and intelligence systems. European NATO forces could work flat out for a month or so but after that stocks, supplies and satellite capabilities would run down. Poland, for example, uses American-made HIMARS rocket systems with a range of 300 miles. But it doesn’t have the satellite guidance systems if it wants to fire them that far. It needs America to guide them.

Three, big defense companies in France, Germany, Italy and Spain rarely agree on contracts and so don’t pool resources. There are regional differences as well. France likes carrier aircrafts, a legacy of empire and operating far from home. Germany wants long-range aircraft and heavy tanks. European cooperation has been hard to come by.

The chart shows U.S. and Western European defense spending. For years, the U.S. did the heavy lifting but things are turning around. Since early 2022, European spending increased 27% from $299 billion to $384 billion. While Europe will trail the U.S. in breadth and sophistication, there has been a defense boom in Europe which looks set to continue.

Here’s a chart of the stock prices of four major defense contractors, Rheinmetall, Saab, Leonardo and BAE Systems compared to the U.S. defense sector stocks.

Since January 2022 prices have gained between 133% to 518% while the U.S. sector has risen 33%.

Part of the success is that companies are ramping up production to meet both NATO requirements and Ukraine aid requirements. Companies focus on three major sectors:

First, drones and surveillance. The big lesson from Ukraine has been the appreciation of air and maritime drones. This includes “loitering munitions,”; drones which hang over targets for hours before they do their stuff. Hensoldt, a German company makes highly sophisticated optronics, sensors and radars that can track 1,500 targets simultaneously over 155 miles, including objects smaller than an iPhone. At the other end, U.K./Portuguese company Tekever makes hand-launched drones that fly at 40 mph for up to 100 miles.

Second, the basic stuff like artillery ammunition. KNDS in France makes mobile artillery units and has increased its order book 130% in a year with orders stretching out five years. William Cook Systems makes track systems for tanks and steel castings for vehicles. It’s one of only two companies in Europe which can make tank tracks. Rheinmetall makes a wide range of sea weapons, munitions and vehicles. It’s seen sales and earnings double in two years and the stock rise over 500%.

Third, missile systems. Sweden’s Saab developed the NLAW a shoulder-mounted anti-tank missile that has come into its own in Ukraine. It also makes aircraft, surveillance, communications and ships. Sales have doubled in the last three years and it has orders for the next five years. Sweden’s defense spending is up 60% in the last four years and, since joining NATO in March this year, it has committed to raise spending from 1.5% to 2.6% of GDP.

The outlook for the European defense contractors looks good and companies have full order books for the next five years, which will boost defense spending. The challenge will be staying at the forefront of technology and navigating multiple government procurement departments. The stock price performance of the leading companies has been impressive. We expect it will remain so.

Bottom Line

We thought we’d update our chart showing the total returns of both the S&P 500 and Treasuries by year since 1929. The returns for the S&P 500 are price-only up to 1960 and total returns from then.

We’ll make two quick points. One, we said it then but 2022 was a bad year. The bond market slump was without precedent. Two, since January 2022, the S&P 500 is up 22% despite the 18% drop in 2022. That’s an annual rate of 8.2%, just below its 50-year average of 11.1%. Sometimes things really do return to the mean.

We’d also note another lesson that comes along regularly. In the first six months of 2024, the S&P 500 returned 15.3% with the small cap Russell 2000 index and the S&P 500 Equal Weight at 1.7% and 4.9%. But since the beginning of the month, we’ve seen the S&P 500 rise 2.4%, the Russell 2000 rise 10.6% and the equal weight at 4.1%. Things move quickly these days. The turnaround in the small cap performance happened in 10 days, mainly because of good inflation numbers. It’s hard to market time when a year’s worth of returns can come in 10 days.

The S&P 500 hit another all-time high this week but gave some of it back on Wednesday. The 10-year Treasury continues to trend lower at 4.17%. There were no major economic surprises. Housing starts came in at 1.3 million. They’ve been between 1.3 million and 1.5 million for a year. Industrial production was at +0.6% mainly because of a 6% increase in light trucks. The U.S. makes around 10 million of these a year so it can have an outsize effect on industrial production.

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Art of the Week: Natalia Goncharova (1881-1962)