July 2022 Global Insights
By Grant Nader
The first half of the year will be remembered as a horrible six months for practically every asset class and investment portfolio.
The second half could potentially be more of the same.
If he were alive Rudyard Kipling would say ‘It is incumbent upon investors not to lose their heads when all about them are losing theirs…‘
Globally we are in a bear market. Rising rates, quantitative tightening and slowing economies leave little room for doubt.
What stands out after two decades in the market is the sheer number of significant risk factors and the level of uncertainty regarding global and regional outlooks economic and market outlooks.
The GFC was a massive crisis but very focused around the financial system, housing, and liquidity. Covid was also a massive crisis but also felt narrow in its focus in that everyone agreed on how to deal with it (massive stimulus and liquidity injections). Currently there are so many challenges from different corners with no single path to resolution and this has driven fear, sentiment, and visibility readings to extreme lows.
The primary recession risks are being triggered by quantitative and monetary tightening and the tightening is being driven almost exclusively by persistent and ugly inflation. We can distill our focus into two higher level questions.
- How long until inflationary forces begin to fall significantly (as this will determine the path of monetary policy)?
- Will there be a recession and if so, how long and how deep will it be?
From these two key questions, several further questions arise in the search for answers and some longer -term questions about the world bear thinking about too.
- The impact of inflation on company earnings
- What should investors do now?
- Europe’s quagmire
- China – bumbling or buying time?
- Geopolitics – what does the world look like in 3 years, time and who are the winners and losers
- Oils long term outlook and Russia-Ukraine
- Food security
Markets are looking for equilibrium and have been pricing in the potential for a recession since the start of the year and this has led to significant multiple compression and a valuation reset. The questions around earnings has not yet been answered and is also a critical one to answer. Some companies may look cheap based on current projected earnings but this will only be know once the outlook is clearer. Companies and analysts have remained fairly upbeat on their outlook relative to what markets have been doing.
What to do now: Sell and buy back lower?
There has been nowhere to hide and many investors are questioning whether to exit equities as confidence plummets. A quick look at history reveals that unless you have the ability to sell now and buy back near the bottom, you run greater risk by selling than by holding on. The market recovery, whenever it may come is usually swift and difficult to identify and the opportunity cost of chasing can be significant.
What to do now: Sell and move to cash?
Given the low yields even after recent rate hikes, it will take years to make you money back. Now this does not suggest markets cannot go lower, but it does suggest that given enough time you will recoup your investment, provided you are invested in reasonable businesses and you stay the course.
What to do in these difficult times: We go back to basics
Stock returns are primarily driven by 3 things –
- Valuation multiple contraction or expansion (we have seen a sharp contraction this year),
- Earnings (sales and margins)
- Dividends, including buybacks (which require cash)
Multiples can expand or contract at any given time, but generally increase in bull markets and contract in bear markets.
Earnings and dividends – It is easy to forget that as an investor you own actual underlying companies that are expected to grow sales, earnings, and cash flows over time, at least in line with the nominal GDP of where they operate.
Assuming the world/country/sector your business operates in continues to grow, a decent business will at least grow with it. Over the long term it is this earnings and dividend growth that will drive returns.
Valuation multiples have had a deep reset, and it may not be over, but this is certainly a better starting point if you are willing to look beyond a few months. For example, US Small cap valuations are at GFC (2008/09) lows and are pricing in a lot of bad news. Exact timing is never certain but clear this is the ‘buy low’ area and should reward long term investors.
Earnings always matter
On the understanding that the only thing certain to drive returns over time is growth in earnings (sales and margin) and dividends we invest in structural and secular growth companies. This ranges from high quality, established growth to smaller emerging growth innovators.
Sharply higher interest rates have hurt valuations across most growth stocks but we continue to invest with a view to compound our portfolio earnings at above average growth rates over the long-term. We hold a core of established blue-chip growth companies that we believe will perform relatively well versus the market through a recession and inflation.
Our satellite allocation to emerging growth has been painful to hold this year but there are some diamonds in the rough that we believe will come out of a slowdown positioned for exponential growth.
Should markets enter into a period of prolonged recession or stagflation, we believe there will be a premium on companies that can continue to grow in a growth scarce environment.
Take a look at the top 3 markets over the past 22 years. The performance of Nikkei suggests equity returns are not only about low interest rates. The top 3 indices of China, India and the US are also the 3 regions with the highest average annual growth rates of the comparatives. Suggesting once again that over the long term earnings (and economies) matter more than interest rates.
Recession: shallow, deep or none – educated opinions differ considerably.
The collective probability of a US recession in the next 12 months has recently been reported as around 50%. If the US does indeed go into a recession, what type of recession will it be? A light, technical recession only, or a more deep recession? This is the critical question to think about since the deeper the recession, the more likely it is that markets have not yet seen the lows.
From where we sit it is difficult to see a situation in which there is no US recession – at best a shallow recession, at worst a deep one. A number of indicators we watch paint a picture of a stretching elastic band poised to snap if pulled much further.
A high-level overview of some of these key markers has us pricing in the likelihood US recession in the next 12 months.
US Retail sales and personal consumption expenditure look strong at face value but these numbers are largely elevated due to inflation. Retail sales in May actually declined 0.3%. This is a nominal measure and if one adjusts it for inflation the implication is that sales volumes declined, not helped by the increased share of wallet of gas prices and other inflation.
Mortgage affordability has risen rapidly – the US 30-year mortgage rate has doubled since last year, for example, the median monthly mortgage payment is up 45% year to date.
Consumer sentiment is at extreme lows, weighed down by inflation fears and falling asset prices, ironically even as the job market remains above full employment. Consumer sentiment is one of the most critical influences on the US economy, with consumption spending accounting for two thirds of GDP and this has a fairly good predictive track record regarding recessions.
Wealth-effects – the brutal sell-off in almost every asset class will most certainly create a negative feedback loop through the natural pull back in spending. Equities and home prices account for the vast majority of US household wealth. Equities are down significantly and home prices have also begun to fall meaningfully which will add to the negative sentiment.
We know that covid led to elevated demand for goods (durables and non-durables), but this has also led to inventory overstocking as a result, as we have seen with the major US retailer updates (Walmart, Target and co.) This demand for goods is expected to slow further as consumers continue the move toward services, such as hospitality, travel and leisure. Destocking of inventory will be a negative drag on growth (yet positive for inflation).
Tightening liquidity and rapidly slowing money supply are also sure to add to economic slowdown pressures. The velocity of money has collapsed to zero and this is an important indicator of a slowdown.
Corporate layoffs are starting to rear their head. The first and most obvious signs coming from the more VC-like technology and long duration, cash-hungry growth companies, but this is the obvious starting point. Thus far the job market has remained very robust, which bodes well for the depth of a potential recession, but it is stretching like an elastic band.
As corporate profit margins come under pressure from the high inflation and sticky upward wage pressure, we fully expect corporates to start shedding jobs fairly rapidly in true American style.
Credit spreads on high yield bonds have widened sharply and continue flashing tightening financial conditions in the market. As the economy slows and profits decline, minimum lending requirements are raised. Fortunately the US corporate balance sheet is very strong overall which should prevent significant credit fallout.
In an inflationary environment, revenues can and should continue to rise even as profits are under pressure which should prevent a GFC type squeeze in credit spreads.
And yet its not all bad news on the economy
The full unemployment (over-employment even) should provide a good shock absorber for the expected job losses.
While PMIs have been slowing, they are not yet in a recession and there are structural capex tailwinds playing out that will underpin economic activity.
The strong consumer balance sheet means they can absorb a slowdown far better than in previous recessions and the rebuilding process post-recession will be a lot quicker as a result.
If the upward pressure on wages lasts longer than the downward pressure on prices there could be a period of real wage increases which would be a welcome boost to consumption and confidence.
Travel and leisure spend is booming as people shift their spending habits.
What are market expectations telling us about inflation?
Inflation expectations are dropping fast, with 5-year TIPS indicating inflation could end up being transitory after all, just later than expected. The expected break-even (i.e. the average expected inflation rate over the next 5 years) has fallen to 2.50%. So the bond market is looking through the political noise and recognising that many of today’s inflationary forces are not likely to be sustained.
The outlook for inflation holds the key to rates and rates hold the key to the recession’s severity
Two of the most severe inflationary forces have been the energy complex and commodities (both agricultural and industrial).
The long term implications of the Ukraine soft commodity supply disruptions are yet to be determined but for the near term at least there has been a sharp reversal in food input prices over the past 1 month.
In addition, key industrial and base metals such as copper, nickel and iron ore have also fallen dramatically.
Critically oil has fallen about 20% which is a positive for inflationary expectations but is most likely a reflection of worsening growth outlook. This is working per the script since it is exactly the type of outcome central banks have been trying to achieve with rising rates.
In assessing the inflation outlook, there are now some major decelerating forces:
- Falling food and commodity prices (as discussed above)
- Slowing global economies (most notably the US, China, Europe) and the associated demand
- House price declines
With an 18 month lag, the correlation between house prices and CPI is clear to see and the recent decline in US housing will help the long term inflation outlook, even though it is not yet showing in the current data (see long term inflation expectations below).
On the other side of the coin, there are also real risks arguing for potential upward inflation shocks:
Energy prices are underpinned by the tightness of Russian supply (barring a sharp economic slowdown)
Food prices are vulnerable to supply shocks if Ukraine cannot get its 45 million tons of wheat and other commodities out to market
Wages have been steadily rising and a wage price spiral is a real risk
The Ukraine war shows no signs of abating, keeping supply pressure on a number of commodities either through shortages or through sanctions
We hope the Fed does not overreact in its mission to reclaim credibility.
There is always a lag between falling prices and embedded annual increases. Even if year-on-year inflation was zero for the remainder of the year, the full year 2022 would still be over 5%. The US Fed needs to be forward looking or they risk over-reacting to the backward-looking inflation data. The bond market has already been pricing this in and by the same token 12-18 month rate expectations are already reflecting some rate cuts by the Fed.
The million-dollar question is ‘can the Fed engineer a soft landing?’. Can they slow things down enough but not too much that there is a deep recession. History suggests this is a very difficult task and they are unlikely to find the right balance. The odds of a meaningful recession are growing steadily, if not already a near certainty.
Earnings and economies
Markets have been desperately trying to price in the murky earnings outlook for equities in this year’s rapid repricing. Valuation multiples have contracted meaningfully but earnings forecasts have only recently begun a meaningful sequence of downgrades. Until there is some comfort with earnings forecasts the valuation multiple (the revaluation of equities) is not clear. Once the market is comfortable that the expected earnings outlook is in line with the worsening economic outlook, investors can begin to assess companies with a little more visibility and decide whether enough has been priced in.
Looking beyond this earnings season, we need to keep a calm unemotional perspective and ask the question – where will future earnings growth come from on a geographic level and also on a corporate level? How are CEOs preparing for the slowdown and how concerned are they? Geographically some areas are easier to invest in than others given the growth outlooks.
Looking past recession and rates, there are some very large and unresolved issues globally.
Europe is walking through mud and political hornets nest emanating out of the Ukraine
Unfortunately, Europe is caught in an unenviable position. Keeping aside the structural challenges they have, there are several reasons to be cautious on the outlook for Europe:
- Dependence on Russian energy has become a real Achilles heel with no clear resolution. The high natural gas prices are sure to squeeze consumers, spending and politicians alike.
- Heavily indebted countries (think France, the PIGS etc.) simply cannot afford the cost of rising interest rates on a fiscal level, while at the same time they are also confronted with rampant inflation.
- There is a not insignificant risk of spill-over of the Ukraine conflict into Europe.
- Fragile currency union
We expected European growth to lag the US and the rest of the world meaningfully barring a sudden resolution in the Ukraine.
Forgotten wars and black swan events: Russia-Ukraine
Outside of the impact on food and energy prices is this becoming a forgotten war? People have moved on with their lives, saddened by the tragedy but the news headlines are slowly disappearing from our daily feeds. It seems to be more and more a war of attrition that Russia will eventually win and then the world will go back to normal is the expectation.
It’s worth remembering the very long and very acrimonious history between Russia and Germany, and also the fact that the European Union is dominated economically by Germany, who is also heavily dependent on Russian gas supplies. As the European winter nears and gas prices squeeze, expect tensions to rise along with it. Taking Europe’s long history of conflicts into account, we would do well not to discount a black swan event out of this flashpoint.
The US has many of its own well documented troubles which are mostly inflation related and have far more control over their own destiny. They are not energy importers, they have full employment and are actually trying to slow the economy down.
Corporate balance sheets remain sound
New multi-year capex cycles
The re-shoring and on-shoring of manufacturing supply chains and products of national importance such as semiconductors are going to require ongoing and significant capex for at least 5-10 years. Capex is foundational to long term economic growth and as such we remain bullish on US economic prospects for the long term across a number of industries.
China – a tale of two timelines
We have previously discussed the risk and implications of China’s own goals, namely the clampdown on big tech, the evolving property market crisis, the zero-covid policy, its political alignment with Russia and determination to assume control over Taiwan.
Any one of the above could have a material impact on the Chinese and global economies, either directly or through geopolitical ramifications.
In the short term, China could provide a much needed positive catalyst to the global economy or in fact make things worse. How and when the full reopening from the near-impossible zero covid approach takes place will impact the unblocking of supply chains and is also likely to be supported by further stimulus measures. Unfortunately this will most likely be a messy process due to the highly infectious nature of omicron (imagine trying to enforce a zero-flu policy?).
Unwinding the destructive red tape and clampdown on big tech will certainly help to restore some confidence to the markets and there are some early, encouraging signs of this already.
Longer term China faces some very real structural challenges
Dictatorship: China is in effect operating under a dictatorship in President Xi Jinping but his questionable covid policies and slowing economic growth are putting him under pressure for the first time. Heading into the National Congress of the CCP, Xi is seeking a renewed term. Dictatorship is only a good thing when the dictator is making good choices for the
Country and arguably choices coming out of China have been questionable of late.
Demographics: For the first time since their great famine, Chinas population is expected to shrink this coming year. This is a direct long term consequence of the one-child policy and is proving nearly impossible to reverse even after new measure to encourage more children.
The long term economic challenges of an ageing population are easy to see when looking at Japan and Europe. China’s declining working age population and ageing 65+ population are going to become a headwind for growth.
The problem: energy is a huge contributor to global input costs across most industries and consequently the biggest instigator behind global inflation, especially as supply chain blockages begin to unwind. As we assess the prospects for declining oil prices, the outlook is gloomy at best if the Russia-Ukraine war rages on.
Russia is the world’s second largest exporter of crude oil after Saudi Arabia. As sanctions increase on Russian oil, some countries such as India and China are willing to step in and buy oil on the cheap and this is alleviating the global demand/supply imbalance.
A decade of underinvestment in traditional carbon-based energy sources has added further structural challenges to the current problems facing the world in higher energy prices. New supply takes time to bring online, and producers are reluctant to overcommit and plough new capex into projects, having been burnt in the recent past by overinvestment. The energy transition push is also an investment risk for oil producers and makes them wary of new capex commitments.
Shale production does hold out some hope as new rigs have a much quicker turnaround time and a faster shut-down time making them ideal for production ramp up. However, the potential for new US supply only partially offsets the expected net shortages globally as discussed above.
In the short term prices are being kept partially in check by:
- Increased shale output (up to 300k bpd)
- Release of US strategic reserves of 1mn bpd
- China lockdowns
- Demand destruction as global growth slows
Unfortunately, most of these are shorter term in nature and do not solve the longer-term issues, especially as the war in the Ukraine becomes more intractable.
Longer term, the net supply deficit will become a bigger issue. As Russia loses permanent production and China ends lockdowns, it’s difficult to see a scenario when oil falls significantly unless we have a material global economic slowdown (a soft recession may not be enough to permanently tilt the scales in our opinion).
The transition to alternate sources of energy will increase in pace and eventually offset the imbalance but this is still a few years out and will not solve the current challenges.
Supply of key fertiliser inputs of potash, nitrogen and phosphates is key to agricultural productivity and the worlds biggest potash producers are Russia, Belarus and Canada. Europe is somewhat out in the cold here again as Canada supplies the US and the Russian and Belarus supplies are being restricted and sanctioned.
A new potash mine and processing facility takes ten years, a nitrogen or phosphate system takes up to 3 years and China, the world’s largest phosphate exporter is limiting supply amid food security concerns of its own.
This means that farmers will either plant smaller areas of land (avoid marginal land) or use less fertiliser per acre of planted land. Either way the expected result is smaller global yields over the next 12-18 months.
According to food security expert Sara Menker, the world has about 10 weeks of wheat supplies in storage (and that is most likely concentrated in certain geographies). Also, much of what we are consuming now is from crops harvested prior to the war and there is likely overestimation of the coming harvest.
Short term, some respite is available with the 45 million tons of trapped harvested product in the Ukraine can find its way out of port.
A number of soft commodity prices appear to have peaked in the near term amongst recession fears and supply resumptions.
Longer term the situation could get a lot worse as we move into the next harvest season later this year (Q3 and Q4), with declining yields and food national food security agenda’s worsening distribution from the producers. We thus recognise there is an upside risk food prices and critical food shortages may emerge in importing nations.
This situation is unlikely to changes while the worlds breadbasket that is the Russia-Ukraine region remains at war.
One positive here is that the higher prices will certainly attract more planted acreage across the globe which should provide some offset.
History tells us now is not the time to sell, even though markets may continue to languish. History also tells us that over the long term, company earnings matter most, and when companies that can grow earnings have rest sharply downwards are on sale, investors should be buying them with a longer-term investment horizon. We aim to identify those companies that have the cash flows to survive and invest during tough times, and the pricing power to thrive in inflationary periods, and the DNA to remain market leaders in their space.