Starting with a war in Europe, 2022 was a year most investors would rather forget.
The Russia-Ukraine conflict led to massive spikes in energy and food costs at a time when post-pandemic supply-chain bottlenecks were already putting substantial pressure on global prices. Central bankers, mostly with mandates to manage inflation, were faced with the very real prospect of a rampant cost-price spiral.
Unusually, they also faced the unenviable task of trying to rein in wage growth expectations at a time when unemployment in most major economies was at extremely low levels.
Despite market fears, we aren’t heading back to stagflation
At the time of writing, headline inflation rates in many countries are still high or increasing. There are legitimate fears that central bank actions may not be sufficient to counter rising wage demands and there is talk of a return to the stagflation (stagnant growth/high inflation) of the 1970s.
However, although the price shock of 2022 is somewhat comparable to that era, it is notable that underlying inflation (often referred to as “core inflation”) already appears to be moderating. This will likely continue over the coming months as easing supply chains, higher borrowing costs, squeezed consumer incomes and falling house prices serve to cool the global economy and dampen demand.
Against this backdrop, it is conceivable that wage demands will also moderate. Many observers point to the ongoing labour shortages in many countries and rapid increase in strike action as reasons to be cautious about wage inflation. However, we suspect that labour flexibility will improve as economies slow. Companies will undoubtedly postpone hiring and trim workforces. Indeed, there are already clear signs of this in the technology sector, where management rhetoric has suddenly caught up with economic reality.
In addition, it is possible that the participation rate, currently at record lows, will increase as non-participants, such as many over-50s, decide to re-enter the workforce.
Finally, it is likely that the recent trend toward labour substitution through automation will accelerate meaningfully, particularly given recent technological progress. While a return to mass unemployment looks unlikely, it is entirely possible that a rise in vacancies, coupled with a modest increase in the number of participants, caps wage costs in the future.
Fears of a deep recession may prove unfounded
An ongoing economic slowdown seems inevitable given the above, but fears of a deep recession may prove unfounded, at least in some markets. With unemployment so low, consumers are better able to weather higher costs. It is notable that household balance sheets, which benefitted from a considerable build-up of savings during the Covid-19 pandemic, provide a buffer for many consumers (although clearly not sufficiently for the poorest income groups).
The picture is similar in the corporate sector, where leverage is relatively low and of longer-than-average duration.
Overall, while material economic challenges remain, inflation may be less entrenched and the economic downturn less severe than many envisage. This is potentially most likely in the US, which is effectively self-sufficient in energy, benefits substantially from the fact that nearly all major commodities are priced in US dollars and has positive immigration. In Europe, including the UK, the picture is unfortunately much more nuanced.
An earnings recession
Recession or not, earnings estimates will have to come down. One of the interesting features of the current market cycle is that while share prices have collapsed, earnings have so far mostly been remarkably robust. The reason for this is pricing.
On both sides of the Atlantic, companies have put through price rises with impunity. In these cases, revenues may well hold up, since consumers appear willing to pay up for premium products. However, for many companies it is only a matter of time before negative elasticity kicks in and demand starts to fall.
Early indications from global mass retailers in the US and Europe suggest that consumers are already cutting their spending. Revenue and margins (excluding energy companies) look likely to fall in 2023, creating a proper earnings downgrade cycle that is yet to be fully reflected.
Our view is that the current bear market has nearly run its course, although volatility is likely to remain elevated for some time to come.
Consensus S&P 500 earnings per share of US$225 and US$235 still look somewhat high, and we expect these to be revised down steadily over the coming months, with the trough to occur in the third quarter of 2023.
Risk and return
We haven’t dwelt on ongoing geopolitical risks, such as further escalation in Ukraine and the possibility of further reduction in Russia’s gas supply to Europe. These are potential “Black Swan” events that are binary in nature and impossible to predict with any certainty.
Any one of these possibilities would be bad for global markets. One must hope that common sense will prevail.
Securing security of supply
We see a wave of government and corporate spending being directed toward achieving greater security of supply: whether through investment in renewables; re-shoring or re-locating production facilities; supporting new methods of food production; or protecting industries that are strategic in nature such as semiconductors, software, or bio-technology.
We are focused on companies that can prosper in a challenging environment and do so with a reasonable level of risk. Many of these are in the areas outlined above, where structural growth rates are clearly higher than they were.
Equally though, as the bear market matures, our research is taking us to several areas that have been out of favour for some time, such as Japan.
There are always opportunities somewhere in the world.
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