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Broad Lowering of Earnings Estimates Likely During Quarterly Reporting Period — Monetary Policy Changes Impact Economic Output Before Prices — Increases Chances for Fed Errors – Post-Covid Era Regionalization Benefits North America – End of Zero Rate Environment – Cash as an Asset — Recognizing Risks, Long-Term Equity Values Likely Created

Date Posted: September 28, 2022

Chair Powell Continued to Caution Against Prematurely Loosening Policy — Investors Finally Listened

Investors, prior to the recent August CPI report, continued to invest, in our view, “hoping” that inflation peaked and would likely decline at a rapid rate. With that “hope,” financial markets seemed to expect the Fed would then begin cutting rates early next year. Instead, if investors examined the “stop-and-go” policy errors made by the Fed during the ’70s high inflationary period, they would not react with surprise and disappointment when the Fed makes clear their aggressive policies. Our past Commentaries showed a chart of the Fed’s 70’s “stop-and-go” policy errors (see Figure 1 plus Figure 2 as an addition). It would seem likely that members of the Fed studied that period in formulating their policy approach. Both at Jackson Hole and at his recent press conference, Chair Powell made the identical comment, “the historical record cautions strongly against prematurely loosening policy,” and repeatedly stated, “maintaining a restrictive policy stance for some time” would be Fed policy. The August CPI report and the Fed Chair’s recent comments finally dashed investor hopes for a less aggressive Fed.

Figure 1

Fed’s 1970’s Stop-and-Go Attempts to Bring Down Inflation

Source: The Wall Street Journal, Labor Department, Federal Reserve

Figure 2

The Fed’s “Stop-and-Go” Policies of the 1970s (Money Growth and Inflation)

Source: U.S. Bureau of Labor Statistics, the Federal Reserve Board, the National Bureau of Economic Research

Monetary Policy Changes Impact Economic Output Before Prices — Increases Chances for “Stop-and-Go” Fed Policy Errors

Many quote Milton Friedman’s phrase from his 1971 speech that monetary policy impacts demand and inflation with “long and variable lags.” As part of that speech, and important with the current monetary policy, he also stated, “monetary changes take much longer to affect prices than to affect output.” Economists’ studies suggest that there could be as much as a two-year lag between monetary policy impact on the economy and its ultimate effect on inflation (see Figure 3). If this proves prescient, then the Fed and investors will face difficult choices over the next two years if the economy declines while inflation persists. It will not be surprising that the Fed “stop-and-go” policy errors of the 1970’could once again be repeated.

Figure 3

Money Supply Growth and Inflation, 2015-2022

Source: U.S. Bureau of Statistics, the Federal Reserve Board, Bureau of Economic Research

Median and Trimmed-Mean Measures of Inflation Continue to Increase—Key to Fed Rate Changes Timing and Speed Inflation Pullback

The Cleveland Fed’s Center for Inflation Research concluded that “the median CPI and 16 percent trimmed-mean CPI can provide a better signal of the underlying inflation trends than either the all-items CPI or the CPI excluding food and energy.“ In that light, while headline CPI did decline in August, median CPI (+6.7%) and trimmed-mean CPI (+7.2%) continued to show a persistent, broad increase (see Figure 4). With these recent results, the Fed faced little choice at its September meeting but to increase the Fed funds rate by 75bps to 3-3.25%. For the remainder of the year, depending on the data, the Fed Chair Powell looks to increase the funds rate 100 or 125bps. That would result in a year-end funds rate potentially ranging from 4-4.5%. Looking to 2023, the key issues for the Fed will be not whether inflation peaked but rather the rate and timing of its decline.+

Figure 4

Median Consumer Price Index–% Change, Past 12 Months

Source: Bureau of Economic Analysis, Federal Reserve Bank of Cleveland

Tight Labor Supply and Its Impact on Traditional Services May Moderate How Fast Inflation Declines

Most economists and investors assume that supply chain bottlenecks for goods principally caused high inflation. Recent slower demand for goods generated investors’ optimism that inflation would moderate by year-end. However, tight labor supply could pressure wages and importantly impact traditional services. For example, the Atlanta Fed’s Wage Tracker (see Figure 5) showed an overall 5.7% annual increase for wages (light yellow line) in August. More specifically, Leisure and Hospitality services showed the highest increase of any sector — 6.3% annually (blue line). Therefore, tight labor markets, as it impacts traditional services, may be the supply constraint that moderates how fast inflation declines. Traditional services account for roughly one-third of core PCE index inflation. The current low unemployment rate and tight labor markets also give the Fed a big umbrella under which it can pursue aggressive rate increases and balance sheet reductions. It should also be noted that unemployment acts as a lagging indicator. Therefore, unless sensitive to that lag, the Fed could overstay its aggressive rate strategy, if unemployment rates remain low, negatively impacting the economy.

Figure 5

Wage Growth Tracker Leisure and Hospitality

(12-month moving average of Median Wage Growth, hourly data)

Source: Current Population Studies, Bureau of Labor Statistics, Federal Reserve Bank of Atlanta


Post-COVID Era, North America Region and the United States will Benefit from a Growing Work Force and Ample Gas Supplies — Corporations will Increasingly Right Shore Their Production to this Region

Despite slow workforce growth in the U.S., that growth rate will still look quite positive when compared to declines in other major countries and regions (see Figure 6). The long-term trend of declining global inflation owes much to China’s joining the World Trade Organization in 2001. However, with a declining workforce, China’s role as factory to the world will rapidly decline over the next ten years. With that change, globalization’s contribution to reducing inflation will also be muted. With the supply-chain lessons learned during the pandemic as well as China’s zero-COVID policies, most corporations will likely right shore a growing proportion of their Chinese production to either other low-cost Asian countries or to regions outside of Asia. With those shifts, the trend away from globalization will likely speed up (see Figure 7). Of the regions outside of Asia, North America will likely receive the greatest benefit. With a growing labor force-albeit slowly — unlike both China and the European Union, North America will gain as global corporations locate new facilities in this region to shorten supply lines and adopt best cost strategies. With limited workforce growth, the United States will likely see increasing capital investments focusing on automation technologies as corporations shift their production here. In addition, the war in Ukraine creates an uncertain and costly outlook for European energy supplies. With ample natural gas supplies in this country, it seems likely that energy-intensive European corporations will shift their future capital investments and production to the United States. Over time, these shifts will benefit North America relative to other regions.

Figure 6

Population Change Aged 20-64 (2020=100)

Source: Natixis, The Daily Shot


Figure 7

Trade as a Percent of World GDP

Source: World Bank, NY Times

Third Quarter Reporting Period Over the Next Six Weeks Will Lead to Lowered Earnings Forecasts for 2023 — Finally Realism — Did Equity Markets Already Adjust to Potential Lower Forecasts?

Financial markets seem to be finally adjusting to the Fed’s aggressive inflation-fighting policies. On the other hand, consensus earnings estimates may reflect a lack of realism by projecting 8% earnings growth in 2023. Recent equity market declines basically reflect lower earnings multiples in response to higher real interest or discount rates, not reduced earnings forecasts. Over the next six weeks, the third quarter earnings reporting period will provide corporations the opportunity to provide their outlook and earnings forecasts for the remainder of this year and, more importantly, 2023. No doubt, those forecasts will be lower than those given during the second quarter reporting period. The result will be more realistic earnings forecasts from the analysts. Some “Street” strategists project that with a soft economic landing, earnings would show little change in 2023. A flattish earnings outlook would suggest recent market declines may ultimately reflect those expectations. However, with a more pessimistic economic outlook, strategists look for a roughly 10% earnings decline. A recent analysis by Goldman Sachs Global Investment Research showed that the S&P 500 Index averages a thirty percent decline—peak to trough– during economic recessions (See Figure 8).

Figure 8

S&P 500 Typically Falls 30% Peak-to-Trough During Recession

Source: Goldman Sachs Global Research


Investment Conclusions

Equities Both post-COVID changes and the impact of the war in Ukraine will lead to future economic and financial forces that will likely differ importantly from those experienced during the last decade. History suggests that bear markets bottom sometime after short rates peak. Assuming a recession sometime in 2023, then the current 20% decline in that index represents that we may be roughly two-thirds through a possible decline. Recognizing the obvious risks, long-term investors should consider gradually taking advantage of attractive valuations on select quality investments created by further market declines. The mark of quality companies includes strong balance sheets along with growing free cash flow, earnings, and, most importantly in our view, growing dividends. In doing so, investors should seek out those sectors that will likely benefit from both post-COVID changes and the global impact from the war in Ukraine. Such sectors would include, but are not limited to:

  • Energy: Green, fossil fuel, and nuclear suppliers
  • Security: Domestic and non-U.S. defense companies
  • Agriculture: Precision farm technology systems and equipment suppliers
  • Commodities: Meeting the growth of alternative energies and electric vehicles
  • Automation Technologies: Supplying productivity improvements to offset global labor shortages

Fixed Income With Fed policies likely leading to the end of the zero interest rate environment, cash becomes a more important income-generating asset. Employing cash, using short-duration Treasury notes and bills, should provide investors with both income and a counter against the high level of economic and financial market uncertainties. In the case of bonds, a note of caution as during the 70’s high inflationary period, bonds showed both negative nominal and real returns. Investors’ outlook for how persistent inflation will be should determine their allocation to that asset. Alternative investments can be used for that portion of the portfolio historically committed to fixed income; alternatives tend to be less correlated with stocks and bonds.

Private Equity and Venture Capital Economic growth depends on both workforce and productivity growth. With slowing U.S. workforce growth, increasing productivity will be key to economic expansion. Venture capital and private equity should be one source of answers to improving productivity as well as proving rewarding to investors.