House View: July 2023

July 4, 2023

A new era has arrived

The first half of 2023 has surprised many investors, especially when compared to the previous and difficult 2022. Growth stocks have shone, and “artificial intelligence” has become a by-word promising a bright and prosperous future. In late November 2022, an early demo of ChatGPT, a chatbot based on a large language model (LLM), was released. Thanks to its mastering of many tasks with impressive ease, particularly being able to communicate a complex context, many market participants see the dawn of a new era to have already arrived.

GOOGLE TRENDS: SEARCH TERM “AI”

Source: GoogleTrends

Memories of 1998-2000 come back, when “the internet” was seen as changing society and the economy in such a profound way that ever rising stock valuations could be justified. The dotcom bubble, as it became known, however got pricked and equities, as measured by the S&P 500 Index and the Nasdaq 100 dropped 47{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} and 82{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}, respectively in the following two and a half years. However, this is not 2000, according to others, citing many differences from the situation of almost a quarter of a century ago.

Inflation not a tailwind for equity valuations

Comparing the period of the late 1990s to today, one prominent difference is the level of inflation: US core inflation, i. e. without the volatile components of food and energy, was in a very stable range of 2.0-2.5{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} during the period of mid-1997 and mid-2000. Two years ago, in May 2021, the core rate stood at 3.8{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} (1.6{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} in December 2020), to increase to a high of 6.6{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} in September 2022 and since has retreated to 5.3{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} – still more than double the high of 25 years ago. The future path of inflation to us appears set to remain above levels that are deemed acceptable by modern central bank doctrine, due to a number of factors, among them a strong negotiation power of labor that will not quickly go away, housing affordability and resulting rent pressure, and a re-pricing of energy commodities reflecting changes in consumer behavior as well as strong efforts of reducing the carbon footprint of today’s living standards.

Equity valuations today strike us as very unattractive if we draw comparisons with other asset classes, most notably bonds. Looking at the earnings yield of global equities, as measured by the MSCI All Countries World Index, vis-à-vis global corporate bonds’ yield to maturity, the difference between the two has narrowed to a large extent, signaling a low equity yield premium over (corporate) bonds. The last time this could be observed was almost 20 years ago, after the 2001 recession and a brutal bear market, when earnings yields, as well as bond yields started to gently rise, until the financial crisis struck in 2008. The driver of the 50{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} gain in equity prices that followed 2004 however were strongly rising profits, benefiting among others by energy and basic resources companies that profited from the boom in commodity prices on the back of China’s rapid modernization. Today, we wonder where a structural earnings driver could come from as we see disproportionately more factors that constrain corporate profits than boost them. 

GLOBAL CORPORATE BOND YIELD & EQUITY EARNINGS YIELD

Source: Bloomberg

Earnings growth constraints

Two important cost factors are weighing on margins: labor and interest outlays. The former is seeing a degree of negotiation power unseen in decades, evident in the highest Atlanta Fed wage growth tracker reading since the series started in 1997. Also, the record high level of open job positions relative to the number of unemployed indicates that wages keep rising strongly. Interest costs on the other hand have only just started to move up, as the effect of central bank rate hikes on the real economy comes with a significant lag. Corporates with access to the bond market for instance are still profiting from the very low yield levels of the past decade, but over time, they will have to refinance maturing paper and lock in the higher coupons, representing a direct hit to net profits.

One may argue that a third factor exists which may be hampering profit growth going forward: tax levels. The effective tax rate on the non-financial US corporate sector has seen a structural decline since the 1950s. We pose the question of whether it is sensible to expect a continuation of this trend – or if we may rather see a reversal, considering the already strained government finances at a time when economic growth is positive, and the unemployment rate at a decades’ low.

US EFFECTIVE CORPORATE TAX RATE

Source: U.S. Bureau of Economic Analysis

Will rates save us?

Looking at the current valuation of certain growth stocks (ten stocks in the S&P 500 were responsible for more than 90{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} of this year’s gains), we see a clear negative correlation between price-to-sales valuation multiples and corporate bond yields – with bond yields leading valuations. Low bond yields (such as during the period 2010-2021) lead to an expansion of valuations (as well as of profit margins), however if (corporate) bond yields move higher by more than 1.5 percentage points, a valuation correction usually ensues. We have already seen a meaningful correction in valuation measures such as price-to-sales multiples in the past 18 months in parallel with the steep three and a half percentage points rise in average corporate bond yields between October 2021 and October 2022. So are all interest-related risks priced into equities? We doubt it, for the primary reason that the interest rate hiking cycle by central banks has still not ended.

US AVERAGE CORPORATE BOND YIELD

Source: Bloomberg

While there are voices that demand more restraint in terms of further rate hikes, as the past 15 months of rising rates need to work their way through the economy, the fact that core inflation (without food and energy prices) remains stubbornly high at above 5{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}, causes many policy makers to be concerned. The longer inflation pressure exists, the more economic agents adapt to such an environment, asking for price increases for their goods and services (wages), perpetuating the upward spiral. Therefore, central banks cannot lean back and watch inflation gently coming down, as every month that passes with the consumer price index rising far above the official 2{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} p.a. goal pushing up wage demands further.

US CORE PCE INFLATION (YOY) AND FED FUNDS RATE

Source: Bloomberg

Looking at the Fed Funds Rate and comparing it with core personal consumption expenditures’ price changes (the Fed’s favorite inflation measure) during the past 50 years, major turning points in inflation were only reached when the Fed Funds Rate exceeded core inflation by more than 3 percentage points, such as in 1973, 1981, 1999, and 2008. During the famous Volcker era, central bank rates stood some 10{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} above core inflation, as measured by the PCE Core index. Today, real rates in this calculation stand at +0.5{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}, which to us is not sufficient to quell the ongoing price pressures, so further hikes look necessary.

Looking at the situation in the eurozone, the ECB appears even more behind the curve, consequently making further hikes likely, with the problem of lagged monetary policy effects on this side of the pond, too. However, real rates remain clearly negative – which to us will not relieve inflationary pressures, until a certain positive level of real interest rates has been reached.

EUROZONE CORE INFLATION AND ECB RATE

Source: Bloomberg

Inflation to disappear on its own?

Base effects are often cited when speaking about the transitivity of inflation. Energy prices make for a good example: if prices double today (after 12 months of stability) and then go sideways for 12 months, energy inflation instantly jumps to 100{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}, and in exactly a year, it will plunge to 0{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}. In a similar line of reasoning, the supply chain issues (e. g. blocked ports, lockdowns in some producing countries) in relation to the Corona pandemic of 2020-22 led to steep price rises. Whether these will all be digested easily, to us is another question. We are convinced that a new environment for monetary policy has begun, with many disinflationary tailwinds for central banks turning into headwinds, such as demographics (shrinking share of working population), the role of China as the “world’s workbench”, and a more confrontational style in geopolitics compared to the peace dividend after the fall of the Iron Curtain.

Another issue mentioned above which complicates the situation for the monetary authorities: adaptive expectations by economic agents. The longer inflation stays elevated, the more the members in an economy expect it to remain elevated. Central banks for this reason must signal further hikes and their determination to axe inflation by hiking towards levels that will sap aggregate demand, as FOMC Chair Powell has stated repeatedly that longer-term inflation expectations by households are of very high importance to the Fed, meaning they are not to rise meaningfully.

But inflation has already come down!

According to one group of economists, inflation has already cooled meaningfully, from a headline CPI inflation of 9.1{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} in June of last year, to 4.0{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} in May 2023. Thanks to base effects, we will soon see a level below 3{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}, this camp says. We believe this to be overly optimistic, considering the median CPI as published by the Cleveland Fed staying at 6.74{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} and another measure, called the “16{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}-Trimmed-Mean CPI” (removing the outliers on both the low and high end, aiming to provide a more stable measure compared to the highly volatile headline rate), standing at 5.54{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}.

The recent University of Michigan survey responses indicate consumers have started to adjust their longer-term inflation expectations, albeit only slowly. The latest reading, published in late June, showed that US households’ inflation expectations on a 5-10 year horizon stayed unchanged at +3.0{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}, despite a 20{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} fall in gas prices in the past 12 months (which consumers often extrapolate into the future).

MEDIAN 5-10 YEAR INFLATION EXPECTATIONS: UMICH SURVEY

Source: Bloomberg

“Huge rock floating overhead”

Chicago Fed President Austin Goolsbee questioned whether the past 15 months of hiking rates led to “a huge rock that’s just floating overhead … that’s going to drop on us?”. Central bankers’ balancing act, in other words, continues. Quite a number of observers are surprised not to see any distinct economic dampening effect of the full five percentage points of hikes, embarked upon since March 2022. Some cracks in the economy nevertheless have started to become visible, for instance the so-called US regional banking crisis that erupted in March and needed to be contained by a new acronym of the Fed, called Bank Term Funding Program (BTFP). We consider it curious that the BTFP loan amount continues to rise, albeit rather slowly, in the months of May and June – indicating continued stress for some banking institutions which need to plug an emergency loan assistance program by the central bank. Based on our view of further monetary tightening, the funding stress for some institutions will not swiftly disappear.

An important factor to watch will be aggregate bank lending in the US, where yearly growth rate has dropped from a rate of more than 12{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} to 6.5{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} in mid-June, and in the past four months has trended sideways (that is, zero growth). Tightening lending standards by bank credit officers plus steeply risen loan rates are working to keep both loan demand and supply in check. A drop in bank lending (partly offset by growth in “private” lending, i. e. by non-bank actors) could well push the economy into recession.

LOANS UNDER BANK TERM FUNDING PROGRAM (USD MILLION)

Source: Bloomberg

LOANS & LEASES, ALL US COMMERCIAL BANKS (USD BILLION)

Source: FRED

AI changes it all

The share price performance of some artificial intelligence-related companies since November has been breathtaking. Total market capitalization of the Nasdaq 100 has reached almost USD 18tn, having risen from below 13tn in late December 2022. One semiconductor producer prominent in AI has seen its market cap triple in the past 6 months, driving its price-to-sales valuation to above 40x. (This reminds of Amazon’s peak price-to-sales valuation of January 1999, when the ratio stood at 45x. While the top of its share price’s bull run of the 1990s only came in December 1999 [25{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} above the January peak], the following 16 months were brutal, with Amazon’s share price dropping more than 90{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} from the top. Such an observation does not exclude the possibility, as was the case with Amazon, of another 18’000{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} bull run in the 22 years following the bottom in April 2001, however.)

The advent of generative AI has led many to expect a huge boost to productivity, as the efficiency gains in many industries are mind boggling, e. g. in software coding (AI supports the programmer with finding bugs in the code, but also suggesting whole parts of the code itself), medicine (AI-aided diagnoses), law (AI-supported litigation preparation) and many more. However, the process of spreading the technology – which is still in its infancy – will take rather decades than months. We would accept its potentially benign impact on productivity, but we deem it far from obvious that long-term labor productivity will be boosted. Considering the dearth of labor supply in many countries and the demographic outlook in many Western societies, but also east Asian ones such as China, Korea, and Japan, some form of substitution of the production factor labor by capital is more than welcome.

US LABOR PRODUCTIVITY: ANNUAL CHANGES (SMOOTHED)

Source: Bloomberg

Observing US productivity gains over the past 50 years, there have been several waves of strong productivity gains, followed by very weak periods. There are voices attributing the strong productivity growth in the late 1990s and early 2000s to the emergence of the internet. However we would pose the question why after 2010, it grew rather meekly, considering the many applications that came to the public in the past 12 years. Productivity tends to be boosted by recessions, as the denominator (the number of hours worked) typically drops more than the numerator (nonfarm business output), driving the resulting ratio up. Whether inflation can be tamed by rising productivity is questionable, if we look at the past decade which was fraught with ever resurfacing deflation fears: productivity gains were the lowest since the late 1970s, which for itself would speak for the opposite of deflation fears, we would argue.

Conclusion

  • The strong equity gains of the past 6 months are based on the expectation that inflation will gently come down and that we will return to a period of calm, supported by negative real rates, and signified by a valuation expansion especially in the growth sector.
  • While inflation is coming down thanks to base effects, the broad movement of price increases has not stopped. We therefore must brace for further central bank tightening which at one point will “break something”. The stress in the US banking sector has not disappeared, considering that emergency funding continues to be drawn by some banking institutions.
  • The imbalance between the market capitalization of US technology stocks seemingly in perpetual growth versus the global energy as well as material sector’s market value has reached enormous proportions. During the last technology hype, in the dotcom boom, the Nasdaq 100’s market cap was less than twice that of global energy and material stocks. Today, it is more than three times their combined capitalization.
  • Since cash delivers the healthiest yields in decades (even in Europe), holding extra liquidity currently to us makes a lot of sense. When exactly “the huge rock floating overhead” (read: economic contraction) will come down on us, of course cannot be said. Should the central banks start cutting rates prematurely, potentially on the back of some form of credit crisis, the problem of persisting rates of inflation will drag even more into the future.
  • We suggest to position a portfolio cautiously, with a dedicated focus on physical (commodities) rather than virtual assets, as we consider the valuation difference between technology stocks and the more mundane commodity extraction industry as extreme and ready to shrink.
  • We also keep our preference for precious metals as well as for a certain exposure towards digital assets as we see an ongoing devaluation of fiat currencies going forward, and a growing taste by the investing public for naturally scarce investments in the face of elevated rates of inflation for years to come.

DISCLAIMER: This document is intended for marketing purposes.

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