Manager prognosis of the economy
In this Q&A with Bob Kaynor, Head of US Small and Mid Cap Equities, we explore some of the most material issues affecting the US economy and learn the thoughts and insights of a frontline portfolio manager facing turbulence in the markets daily.
Do you believe inflation has peaked? If not, when do you expect it to do so?
The headline rate may have peaked in March. However, with inflation remaining at its highest levels in more than 30 years, investors are asking what it will take to bring it down. Broadly speaking, we believe inflation will remain sustainably higher than the low levels we experienced during most of the 2010s. There will still be pockets of inflationary pressure across materials and supply chains, but the relentless inflationary pressure that has pervaded all businesses, including labor in many areas, is subsiding.
Given that you believe inflation has peaked, what is your longer-term outlook on its trajectory?
The return to normal looks like it will take longer than previously expected as supply constraints in commodities, ports and the labor market are unresolved. Although headline inflation is peaking and will decline in coming months, core inflation is likely to be stickier. The Federal Reserve Bank of Atlanta offers an explanation of this issue: the “sticky” price inflation measure breaks down price changes by the frequency with which firms adjust their price lists.
Commodity related prices are flexible and tend to bounce around frequently so they can reverse quite rapidly too. By contrast, stickier prices such as rent, and housing move more slowly. Flexible prices are currently at new highs, but sticky prices are also at their highest levels since the late 1980s.
We suspect inflation will settle at a level higher than the Federal Reserve’s 2% target for a sustainable period of time. One reason for our view is global supply chains have changed. They are no longer about low-cost geographies and just in time inventory management. Companies are willing to incur more cost to ensure availability of goods. “Just in time” is becoming “Just in case.”
Are you positioning your Small and Mid Cap investments for expected changes in inflation?
We do not position our investments in line with macroeconomic factors because we invest across a four to five-year time horizon on average. In any case, companies do not necessarily correlate directly with changing economic indicators. In general, we like companies with optionality in their business model because they can cope with changing environments.
Additionally, our conversations with companies indicate easing pressures on labor and certain components of the supply chain. Based on these insights, we are targeting companies with revenues that are not overly sensitive to the economic backdrop, where the cost pressures of labor and transportation have been holding back margins.
Do you expect the US economy to fall into a recession anytime soon? 2022-2023?
Our expectation is that the FOMC will remain committed to further tightening. Indeed, our analysis suggests that a recession may actually be a necessary trade-off for lower inflation, despite hopes of a “soft landing.”
Essentially the central bank must restore the balance between supply and demand such that there is sufficient slack in the economy to ease wage and price pressures. To achieve a soft landing, the central bank must pursue this goal gradually so that the growth rate slows below trend rather than crashes into recession with output falling and unemployment rising rapidly.
Of course, this is easier said than done.
With first quarter earnings mostly behind us, what are your expectations for the remainder of the year? Do you expect negative earnings revisions from here?
We do expect earnings growth expectations to be revised downwards but overall earnings to remain positive especially for Small and Mid Cap companies. They are generally more domestically biased and therefore protected from a strong dollar. Domestic demand is still strong, but it is becoming patchy, necessitating skilled management.
Strong nominal growth of revenues should allow companies to leverage fixed costs and earnings growth, even if that growth is lower than current expectations.
In which US Small and Mid Cap sectors or industries do you expect to see the strongest potential positive revisions? Which might see earnings revised downward?
Semiconductors – Demand and margins remain strong.
Healthcare – Some areas previously impacted by labor shortages are improving.
In general, we are more favorably disposed to a commercial spending cycle in which budgets have been approved, money must get spent or lost and the reaction time to a changing economic environment tends to be slower. This can also include infrastructure, municipal spending and commercial construction.
Consumer discretionary – A combination of peak margins and difficult inventory management in the face of changing demand will impact earnings negatively. This industry has benefited from lean inventories because of supply chain issues, strong consumers who received mailbox money and easy comparisons. All of these factors are changing.
The debate on how much economic news is already discounted in the market persists. There are certain areas of the market, including some cyclical stocks, that are trading at trough valuations and yet have continued to see positive earnings revisions. How these sectors behave when earnings begin to rebase will be a good indication of what is priced in.
We do not expect a financial crisis given the strong balance sheets of both corporations and consumers. Moreover, there is a willingness of governments and central banks to operate with excessive leverage across the developed world.
US companies are currently functioning in an environment that few managers have witnessed before. Generally, there is strong demand, but an unfortunate bedfellow is high-cost inflation. The need for superior stock picking skills will be much more prominent in the future as compared to past years, when markets rose strongly in an era of easy money.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.