Highlights
· Central bankers across most major economies seem to be aligned in their views that the longer inflation is allowed to persist, the harder it will be to bring down.
· In a testament to the abnormality of the times, good economic data is being greeted with sell-offs in the equity markets because investors interpret such news as adding fuel to the fire for further rate increases.
· The economy is far more complicated than most people want to admit and investors should avoid making investment decisions based on economic forecasts.
Commentary:
“We know what has happened in the macro environment and what is happening today. We know what most people think will happen in the macro environment moving forward, and we know where security prices are today. What we don’t know is how much of what we think will happen in the macro (or what others think will happen) is reflected in today’s prices. Since future conditions (as opposed to present conditions) may already be incorporated in prices, a poor macro outlook isn’t necessarily synonymous with prices declining, and a good macro outlook needn’t be synonymous with prices rising. Investors should be wary of sweeping generalizations about whether it’s time to buy or sell.
-Howard Marks, Co-Chairman, Oaktree Capital Management
After staging a comeback in July, driven by anticipation of a potential slowing in the pace of future rate hikes by the Federal Reserve (Fed), equity markets resumed their downward spiral in August and September when it became clear that was wishful thinking. The Fed continues to be laser focused on bringing inflation back in line with its 2% target. As of the writing of this report, year-over-year U.S. inflation continues to come in at over 8%, driven largely by price increases in shelter, food, and medical care. The food index in particular is hitting consumer pockets hard, with increases at levels not seen since 1979. Downward pressure on gas prices and energy during the quarter helped to somewhat temper these increases.
Sharply raising borrowing costs during what appears to be an imminent global recession will do more damage to the global economy in the short-term. Many companies have been able to push through price increases to their customers, but others are finding that their costs are rising faster than their price increases. Developed market central banks are betting that bigger rate increases now will help prevent inflationary expectations from taking root among businesses and consumers and prevent a lengthier period of detrimental rate increases in the future.
One of the basic requirements for a recovery in the equity markets is to avoid a deep recession. The U.S. is already in a technical recession, where the economy shrinks for two successive quarters, but needs to avoid the sort of recession where earnings are pulverized by extensive layoffs and belt-tightening. To this point, the job market remains strong, with low unemployment and strong wage growth. The biggest U.S. companies have continued to spend on capital projects such as real estate, equipment, and technology to fuel future growth. Capital investments are generally intended to expand companies’ fast-growing operations or optimize inventory during a challenging business environment. It is generally a bullish sign when executives are comfortable spending money instead of hoarding cash or repurchasing stock, but of course, this sentiment can change on a dime.
Typically, a strong labor market and robust capital spending are tailwinds for the economy, but these are not normal times. Strong job reports are being met with expectations that the Fed will continue to raise interest rates sharply because the Fed has concluded that the job market is overheated and that the only way to bring down inflation is to cool it off. While we believe that a strong economy with robust consumer spending and historically low unemployment is good for stocks over the long term, we appreciate the balancing act the Fed is trying to pull off in the shorter term to satisfy its dual mandate from Congress of low unemployment and price stability.
This is why, unlike in previous recessions, the markets are not likely to get help from the Fed anytime soon. Jerome Powell made it clear at the Jackson Hole Economic Symposium that was held in August that it is going to take a lot for the Fed to be convinced that runaway inflation has been fixed. Powell said he does not agree with economists who believe that inflation has peaked and the Fed “must keep at it until the job is done.” He went on to say, “These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.” Likely the external headwinds from the Russia-Ukraine war and lingering effects of snarled supply chains from the pandemic and the war need to improve, and the job market needs to ease, before the Fed feels comfortable enough to shift its focus from inflation and aggressive rate increases, to economic weakness and easing again.
Another nuance of this recession is that poor and working-class Americans appear to be holding their own, whereas typically they are hit the hardest because they are often among the first to be fired and lack the financial resources to ride out a downturn. This time around, employers are struggling to hire and wages for lower-income people are rising at a faster clip than for people with higher incomes. This wage growth makes it easier for lower-income workers to keep up with inflation.
Elsewhere, the British pound crashed to a record low against the U.S. dollar in September on growing fears about the stability of U.K. government finances. The slump in the pound followed an earlier announcement by the British Chancellor of the Exchequer that the United Kingdom would implement the biggest tax cuts in 50 years at the same time as boosting government borrowing and spending in the face of double-digit inflation. This prompted the Bank of England to announce it would buy U.K. government bonds with long maturities “on whatever scale is necessary” in an effort to restore order to the borrowing market. The Bank of England is prepared for a recession that is as long as the one that followed the 2008 financial crisis, but not as deep, due to persistently high inflation and falling household income. Newly elected Prime Minister Liz Truss subsequently fired the finance chancellor and backtracked on the proposed plan to cut income-tax rates for top earners, a move that was cheered by investors, but seen as a setback for Prime Minister Truss’s economic agenda.
Inflation in the Eurozone rose to a record 10% and surpassed U.S. levels during the third quarter as Russia withheld supplies of natural gas, which drove up energy prices amongst uncertainty about the area’s ability to make it through the winter without power cuts. Price increases were not limited to energy, as nearly all segments of the bloc’s economy showed price increases. The economic shock from the war, resulting energy crisis, and record inflation pressured the European Central Bank (ECB) to raise its key interest rate by the most since the early days of Europe’s monetary union, and unveil a plan to buy the debt of Europe’s most vulnerable economies. The large rate increase should help support the value of the Euro, which had declined to a 20-year low against the dollar due to the ECB signaling earlier in the year that it would not match the Fed’s vigorous interest rate increases. A weak Euro increases the costs of Europe’s imports and makes it even harder for the ECB to bring down inflation to its medium term target of 2%.
China does not have an inflation problem, but they do have an economy struggling to grow in the face of a property bust and zero-tolerance to Covid-19 that is stifling consumer spending. This unexpectedly led the People’s Bank of China to trim two of its policy rates during the quarter in response to slowing growth and weak demand for credit. Banks in China soon followed with cuts to benchmark interest rates on loans to consumers and businesses. Chinese policy makers are likely to make additional small cuts to interest rates, but are unlikely to unleash the kind of enormous stimulus response they have engaged in when confronted by prior episodes of slowing growth due to concerns over faster inflation and ballooning debt. Based on what is happening in the U.S. and Europe, this would appear to be a valid concern.
As gloomy as the outlook might seem in China now, the longer-term growth prospects for China, and emerging markets in general, remain intact. Many of the factors that made the last decade of growth in the U.S. electrifying can be applied to emerging markets over the next decade. Over 1 billion people in China and India alone do not currently have access to the internet. Many of the technologies that propelled the U.S. forward are beginning to play out in emerging markets, where for every Facebook there is a TikTok, and for every Uber there is a Didi. Arguably, China is already ahead of the U.S. in other areas such as electric vehicles and renewably energy.
This does not mean there are not significant short-term challenges for the developing world. Higher food, energy, and fertilizer prices caused by the war in Ukraine, rising interest rates, currency devaluation, and capital outflows have the propensity to create a perfect storm that could lead to under investment in developing countries and hamper future growth.
You might conclude from reading these commentaries that we know a lot about the global economy, but that is not a claim we would ever make. The economy, and the world for that matter, is far messier and complex than most of us want to admit. These commentaries merely summarize what has happened in the recent past. We are the first to admit that we cannot predict what the future has in store for the global economy and what impact economic variables will have on equity markets. If nothing else, the 21st century has proven thus far that the biggest risk to the economy and investor’s portfolios usually turns out to be something nobody saw coming at the beginning of that year – 9/11, the collapse of Lehman Brothers, the Covid-19 pandemic, Russia invading Ukraine. The entirety of the 20th century was no different, despite human inclination to remember fondly the days of yore, even though there were inevitably more challenges, and it was less comfortable, than people tend to recall.
Niall Ferguson, one of the world’s prominent historians, wrote the following in Bloomberg Opinion on July 17, 2022, which we believe underscores how difficult it is to make predictions about the economy and why investors should not make investment decisions based on economic forecasts:
“But consider for a moment what we are implicitly asking when we pose the question: Has inflation peaked? We are not only asking about the supply of and demand for 94,000 different commodities, manufactures and services. We are also asking about the future path of interest rates set by the Fed, which — despite the much-vaunted policy of “forward guidance” — is far from certain. We are asking about how long the strength of the dollar will be sustained, as it is currently holding down the price of US imports.
But there’s more. We are at the same time implicitly asking how long the war in Ukraine will last, as the disruption caused since February by the Russian invasion has significantly exacerbated energy and food price inflation. We are asking whether oil-producing countries such as Saudi Arabia will respond to pleas from Western governments to pump more crude. We are asking how much damage President Xi Jinping’s policy of “Zero Covid” will do to the Chinese economy, and hence to East Asian demand for oil and other commodities.
We should probably also ask ourselves what the impact on Western labor markets will be of the latest Covid omicron sub-variant, BA.5. UK data indicate that BA.5 is 35% more transmissible than its predecessor BA.2, which in turn was over 20% more transmissible than the original omicron.
Good luck adding all those variables to your model. It is in fact just as impossible to be sure about the future path of inflation as it is to be sure about the future path of the war in Ukraine and the future path of the Covid pandemic.”
The investment policy we advocate concedes that the future is uncertain and that recessions and bear markets are inevitable, but emphasizes the need to stick to your long-term investment plan in the face of adversity. As former GE executive Ian H. Wilson once said, “No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future.” Or as financial author and investor Morgan Housel said, “If you’ve relied on data and logic alone to make sense of the economy you’ve been confused for 100 years straight.”
Discipline is often hardest at market tops and bottoms when greed or fear typically become most powerful. Experienced investors know that they always have and always will need to accept that periodic tough years are unavoidable. That does not make living through tough years like this one any less unenjoyable, but enduring them is critical to long-term investment success. A bell is never rung at the bottom and the best gains in a bull market are typically made in the first few months of the rebound. Experienced investors also recognize that equity markets are prone to increase over the long-term, largely in part to the resourcefulness and profit-maximizing efforts of company leaders that is eventually reflected in the increasing value of equity prices. Despite today’s considerable challenges, we continue to believe whole-heartedly that adherence to our investment approach will provide satisfactory investment returns over time.
Urban Financial Advisory Corporation – October 2022