This week we have reviewed cyclical and secular trends as it relates to growth and inflation and how these trends may impact asset markets.
But first, an analogy to help us work through the current environment. For those of us that have driven in winter conditions and snowy roads (similar to the picture above), the first rule is to drive slowly (even with snow tires). It’s harder to control or stop your vehicle on a slick or snow-covered road. Increase your following distance enough so that you’ll have plenty of time to stop for vehicles ahead of you. Take the time to learn how a vehicle handles under winter weather driving conditions.
We use this analogy for the challenge that lies ahead for the central banks as they are driving on a snow-covered road (a slowing economy) and have several potential options: 1) keep increasing rates and cause a significant economic downturn (going over the cliff as you round the curve in the picture above) 2) pause and wait for the lagged impact of existing rate hikes/potential economic damage, and 3) start easing off too quickly and have inflationary pressures re-emerge quickly.
1) Cyclical Trends
Stock markets have been positive 2023YTD and trading close to the 200-day moving average: this appears to be a technical reversal given the bearish sentiment coming into 2023 (weak H1/23, followed by H2/23 recovery). With inflation momentum slowing, a soft landing has become a potential market narrative and financial conditions have loosened since November, however, leading indicators point to further economic pressure and lower EPS in 2023. China’s re-opening and liquidity impulse is expected to be positive and may offset weakness from the rest of the globe.
Current corporate earnings trajectory may be unsustainable (S&P 500 EPS for 2023F at $225/share represents 13% growth over 2022F) and profit margins are elevated – well above historical trend and margins have reverted to the mean. Consensus EPS have not considered an Earnings recession in 2023. Recessions tend to have (23%) declines in Earnings during recessions since 1949. Based on survey data, pricing power has been diminished and increased labor/input costs are outstripping price increases which compress operating margins. This behavior has lead to layoffs in the past. Q4/22 Earnings season has kicked off this past week and we expect a lowering of future 2023 guidance over the next few weeks.
Disinflationary trends: Despite the headlines, wages and inflation momentum are falling in lock step back to pre-COVID-19 trend lines. Slowing energy prices have reduced inflation momentum as well. The Fed and administration need to keep inflation expectations anchored to keep interest rates manageable and avoid a similar sovereign debt crisis as we saw with UK in 2022. Bringing down energy prices has been major help in alleviating a surge in inflation, which then influences inflation expectations. A big driver behind the fall in Energy prices has been the Strategic Petroleum Reserve (SPR) – a reduction of 50% during 2022. Given the pace of the rate hikes in 2022 and lagged impact on the economy, we likely have not seen the full impact of the tightening yet.
Leading indicators continue to decline and have yet to bottom and point to a recession in H2/2023. Coincident indicators are still positive, though growth is slowing. The labor market has yet to see significant stress, though lower hours, less temporary staff, part-time and less job openings. These trends tend to occur before full-scale layoffs.
An uncertain macro environment is supportive of a trend-following strategy (long-term bonds, gold, and IG Bonds for the current month)
2) Secular Trends
Corporate Earnings and Stock Price (going back to 1881) are well above long-term trends. Recession tends to bring back EPS/prices to historical trend line.
Shiller’s Cyclically Adjusted Price-to-Earnings Ratio (CAPE) (10-year Price-to-earnings) ratio can be modeled using a macro multifactor model of long-term growth and inflation, cyclical deviations, and volatility of growth/inflation.
1)Multifactor Model based on CAPE (dependent variable) and independent variables (average growth (industrial production) over trailing 10-years, average inflation over trailing 10-years, macro uncertainty (standard deviation of growth and inflation over last 10 years), 3-year growth as % of 10-year growth, 3-year inflation as % of 10-year inflation and macro uncertainty (3-year standard deviation of growth and inflation as % of 10-year standard deviation of growth and inflation. )
Higher long-term inflation above 4% and associated inflation/macro uncertainty have historically compressed CAPE below the average of 22x. Historically, valuations/wealth are maximized in low, stable interest rate environments (1960-1970, 1992-2022).
Less globalization/war/pandemic increases macro uncertainty. Macro uncertainty leads to equity market volatility and reduces valuations/wealth.
Secular forces that have been sped up as a result of COVID-19 (de-globalization/war/multi-polar, larger wage share of GDP/populism, increased wealth/income equality, de-carbonization) point to higher trend inflation (beyond the target of 2%) and more inflation uncertainty. This points to trend inflation between 2.5% and 3.5% going forward and may compress the CAPE ratio closer to the average of 22x from current 29x.
1)Based on the multifactor model Core PCE (dependent variable) and independent variables (Income/Wealth Distribution), Globalization (imports as % of GDI), Employment-to-Pop (25-55 years), Commodity prices, Technology adoption, and Federal Debt as % of GDI. Trained on the 2010-2019 period.
