Our planet just can’t seem to catch a break. Just as countries, economies and markets were all beginning to emerge from last year’s Omicron surge, Putin did the unthinkable and invaded neighboring Ukraine with a ferocity and brutality that shocked the rest of the civilized world. Six weeks after the invasion, we continue to see daily images of the vile crimes being committed against the Ukrainian people and we continue to hope and pray that the aggression will end soon. The prospect of the Western world being drawn into an escalating conflict further clouds an already-difficult macro environment. From a market perspective, investors have collectively endured gut-wrenching bouts of volatility as financial assets were repriced due to heightened geopolitical risks. Aside from commodities, virtually all other asset classes declined during one of the worst quarters for financial market returns since 1981.
Figure 1: Few Places to Hide in Q1 of 2022
Source: Ned Davis Research
When the facts change, they change. At the start of the year, we were feeling optimistic that a more benign scenario and a gradual transition to a tightening regime was the higher probability outcome. Unfortunately, in the short span of just a couple of months, the calculus now appears to favor a more difficult path forward as the one-two punch of the Russian energy price shock combined with a new round of virus-related shutdowns in China are exacerbating rising inflationary pressures. Around the world, central banks have been removing liquidity at an increasingly rapid pace with global short term interest rates nearly doubling over the last year.
Figure 2: Central Banks Hitting the Brakes
Source: Piper Sandler
Why are short rates so important? Because they are key inputs to the cost of money and excellent indicators of the likely future path of Purchasing Managers Index measures (PMIs). PMIs provide insights to new orders, production, employment, inventories as well as supply chains. While not a perfect predictor of forward economic conditions, they have a very strong correlation, and we believe are one of the best indicators of what’s to come.
Figure 3: What Drives PMIs?
Source: Piper Sandler
Why do we care so much about PMIs? Because they are also excellent indicators of forward market returns. Over the past many quarters, we have written that the US (and global) economy were healthy and extremely resilient, and those conditions remain true today. The fundamentals of strong housing, healthy labor markets combined with relatively loose financial conditions still have not changed. What is changing though, is that financial conditions are becoming much less loose as the rising costs of money and goods erodes consumer real disposable income, consumer confidence, profit margins…and ultimately corporate earnings.
Figure 3: PMIs Declining…and Headed Lower
Source: Ned Davis Research
Recall that the US (and much of the global) economy is predominantly driven by consumer spending. The effects of the pandemic-era stimulus money have faded away as consumers are now facing falling real disposable incomes. Question: How can real incomes fall when nominal wages have been rising? Answer: Because inflation is rising at a faster rate than wage gains. We still do not expect a wage price spiral due to continued productivity improvement as well as rising labor force participation rates as people return to work. If our thesis is correct, with wage growth slowing and real disposable incomes declining, we have entered an era of demand destruction.
Figure 4: The Consumer Faces Tough Choices Ahead
Source: Piper Sandler
Remember the Fed and other central banks are tightening monetary conditions to slow down inflation in a backdrop of a very healthy economy. The Fed has a dual mandate of maintaining full employment and price stability. With employment back to pre-pandemic lows, the Fed can squarely set its sights on quashing inflation with the comfort of knowing it has the fundamental support of strong housing and labor markets. This is not likely to be a pleasant process. While our base case is that the Fed will not tip us into recession any time soon given the strong fundamentals, we acknowledge that the risks are rising.
Figure 5: Significant Growth Slowdown Ahead
Source: Bloomberg, Blackstone
The Fed has made some pretty hawkish comments as of late and we are not ones to second guess or try to outsmart what we think they should be doing. The old adage of “don’t fight the Fed” remains as true today as it ever has. The equity markets have priced in an aggressive Fed hiking cycle and price/earnings multiples have declined in response. Of course, there is a reasonable chance that the Fed does not tighten as much as the markets expect over the next year, which would provide impetus for the next cyclical equity rally. Inflation though persistent, is starting to ebb and if growth slows rapidly enough, the Fed will likely have to reverse course…yet again.
So, are we there yet? We’re not so sure – while we think the markets have rationalized higher geopolitical risks, stickier inflation pressures and a more restrictive monetary regime, we don’t think equity prices are fully recognizing the corresponding earnings slowdown given the higher input costs (due to inflation) and slowing consumer spending (due to declining real disposable income).
Figure 6: Is Demand Destruction Priced In?
Source: Piper Sandler
To recap, growth was already slowing due to rising inflation. Now that the Fed has embarked on its own tightening cycle, growth will slow further, potentially risking the onset of a premature recession. Persistent inflationary pressures are starting to ebb given declining demand due to falling real incomes, which will reduce nominal spending and corporate revenue growth…and it’s hard to grow earnings when revenue growth is set to slow. Which brings us back to PMIs. PMIs tend to be an excellent predictor of earnings growth, which is a key input to stock prices.
Figure 7: PMIs – Earnings Growth – Market Returns
Source: Piper Sandler
We are firm believers that asset allocation is the predominant driver of portfolio returns. Keeping a healthy allocation to equities, even in the face of slowing earnings growth is critically important because in the long run, equities are excellent assets to offset the effects of inflation and preserve purchasing power. Earnings grow over time, and it is important to not get too caught up in cyclical headwinds or fear of short-term volatility. Fixed income, while not outpacing inflation at present, still offers an excellent hedge to equity market volatility and Real and Alternative assets offer inflation protection as well as access to uncorrelated returns.
As active managers, there is always some action to take in portfolios, given the dynamic outlook ahead. We continue to reduce the duration (sensitivity to interest rates) in equity, fixed income, and real asset classes in portfolios. We are also updating equity profiles to emphasize exposures to companies that have stable earnings, higher profitability and stronger earnings growth as these factors tend to do well in a backdrop of declining PMIs. Lastly, we are increasing allocations to Private Capital vehicles for our clients as we believe these tools and strategies are ideally suited for this environment.
Reiterating what we wrote last quarter, navigating this environment has been challenging and we know this recent volatility has been uncomfortable for many of you. Long-term horizons can suddenly seemingly get very short in market conditions like these, and we encourage you to speak with your Relationship Manager if you have thoughts or concerns about the markets. We are here for you.
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