A Sustained Reopening: 1Q 2022 Outlook
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- The cost of capital was set far too low for too long and needed to rise significantly.
- Risk premiums are elevated but should improve once inflation is under control.
- Don't sleep on the early cycle cyclical businesses.
- Don't get sucked into the silly-verse. A malinvestment bubble has sucked a considerable amount of capital from many sources.
The fox knows many things, but the hedgehog knows one big thing
This ancient Greek aphorism shows up episodically in literature, including financial literature such as Barton Biggs’ 2006 classic of modern finance Hedgehogging. The gist of the aphorism for financial market purposes is that it is sometimes better to focus on one big thing, whereas in other times knowing a little bit about a lot of things is more valuable.
2022 was, undoubtedly, a year for the hedgehogs.A lot happened that one would not have (credibly) predicted in late 2021.Russia invaded Ukraine.Russia’s army appears unable to beat the Ukrainian army. China persisted in COVID-Zero policies until mid-December.Most people in the USA just stopped caring about COVID by mid-year.A “clean” baseball player beat the all-time single season home run record in a year with fairly poor average offensive statistics.Markets declined sharply all year, but the VIX “fear” index peaked in January.
All are interesting facts that run somewhat counter to intuitive expectations. But one big fundamental fact dwarfed them all:
The cost of (risk-free) capital was set far too low for too long and needed to rise significantly.
Intuitive expectations ran counter to the severity of the mispricing of the cost of capital entering 2022, given years of low inflation and Central Bank actions to augment inflation that had persistently undershot goals. But the low-flation era appears to have ended in the post-COVID world. While signs of speculative excess and inflation were abundant for most of 2021, monetary authorities’ collective denialism and their own policy excesses led to an aggressive liftoff from years of negative real interest rates.
Prior to 2022, real expected rates were negative for all of 2008-2022 but for a brief period in 2018
- Most longer duration financial assets were not priced for it.
- Most speculative financial assets were definitely not priced for it.
- Most currencies were not priced for it.
- Most risk-free assets (long bonds) were not priced for it either.
The cost of risk-free capital is among the most critical variables in any financial calculation of long-term value for stocks, bonds, real estate, currencies, inventory, commodity futures, you name it... Thus, having had it systematically mispriced required a broad and significant repricing of financial and real assets.
Value stocks, which had dogged it for all of the 2010s, embedded a higher cost of capital and held up relatively better in 2022. Many parts of the physical economy have received minimal investment capital for many years given the bubbly valuations and rewards for more new-age businesses. The cumulative imbalance, along with economic scarring from COVID, altered the relative risk/return in markets and key economic sectors, some of which “overperformed” from the benefits of a low cost of capital and a very distorted economy.
Toward the end of 2021, the U.S. Federal Reserve began an awkward process of trying to both walk and talk its way out of a corner that it had painted itself into. It had repeatedly injected spectacular quantities of money and liquidity into the financial system during the COVID pandemic, presumably to offset a potential credit collapse and deflationary urge. When neither of these scenarios materialized, a very basic problem emerged. Supply chains worldwide were scarred by two years of COVID disruptions, accompanied by across-the-board social and financial welfare. These combined to create a potent cocktail of well-financed excess demand and physically challenged supply – a perfect formula for inflation and interest rates to finally break out of a multi-decade downtrend – along with popping varying asset bubbles in the financial world.
That was 2022. Is there a “one big thing” to bear in mind for 2023? Or is the one big thing already so well-reflected in asset prices that more fox-like behavior will be rewarded?
For 2023, we believe an overwhelming dose of hedgehog single-mindedness probably leads to the wrong outcome. But it is still important to keep the big real interest rate and real cost of capital picture squarely in mind.
Let’s start with the obvious: there will be a sustained higher cost of liquidity as Central Banks reach cruising speed in restrictive territory, hold there, and drain off money supply over the next 1-2 years. An economy and financial market very acclimated to a low cost of capital isn’t likely to thrive with restrictive monetary policy. Realistically, this bounds upside in terms of multiples as well as financial and economic activity.
Maybe the year is flat with a lot of ups and downs. However, the aggressive Fed playbook is well understood by market participants – with Fed Funds’ rates at 4.5% entering the year, most of the tightening process has been completed. A period of below-average economic performance (whether recessionary or not) is widely anticipated as necessary to break inflationary pressure. This is already baked into equity and debt markets, at least to some extent; i.e., cyclical stocks are in many cases back to 2020 pre-vaccine prices, while today’s fixed income markets include one of the steepest yield curve inversions on record. It would be more surprising to the markets if a recession were avoided. Whichever it is, recession or super slow (but still positive economy), neither are consistent with high earnings growth, high margins, etc. Longer duration growth stocks still face valuation risks, even after a rough 2022.
Risk premiums are elevated
By the middle to latter parts of the year, the Fed and other Central Banks should show some signs of getting inflation under control. To the extent they are successful, markets ought to begin to reflect something other than earnings and multiple expectations under highly restrictive monetary policy. This can (potentially) lead to lower risk premiums. Inflation is a backwards-looking economic statistic; it tells you what just happened and not what’s going to happen. More forward-looking measures, such as the ISM survey, pending new home sales, business inventories, and bank officer surveys, all show an economy that is far from white hot if not poised to contract, with a negative inventory cycle already well-along. This should move into services pricing and real estate/rental equivalent cost pricing, which both loom large in aggregate inflation statistics. The Fed and other Central Banks do not directly control inventories or bank surveys. They control interest rates and money supply. Money supply, as measured by M2, has fallen monthly since mid-year and is widely expected to post negative year-over-year growth in 2023, a first since the Great Depression. A persistent money supply decline is not consistent with racing inflation. We can’t forecast inflation very precisely over the year, but it’s reasonable to expect headline inflation to fall to the 3-5% range by mid-year (if not lower). Will markets rejoice in a partial victory? That’s quite possible, based on current risk-asset pricing/risk premiums.
Looking at risk-free bond yields and embedded risk premia in corporate bonds, these variables have moved from unusually low levels in 2021 to levels associated with moderate stress as of late 2022. This is a positive – investors ought not fear a sustained move higher in the cost of capital in 2023. It’s already reasonably high in a historical context. But indeed, it can go higher…
Above the post GFC average
Well above the post GFC average, but still a bit below pre-GFC.
Also elevated versus the post GFC average, but not especially stressed…
Don’t sleep on the early cycle cyclicals
There are a range of early-cycle businesses (industrial, consumer, financial, technology, automotive…) that would trade at far higher valuations than they do presently if it were not for this looming period of weak economic and financial conditions. We just have to get through it, or to a period where you can start to see an end to it, for these businesses to thrive. Arguably, by late 2023, economic conditions should be a lot closer to a stable price environment than they are at present. While market participants lean conservative and defensive, anticipating a recession, at some point markets will expect something other than a recession. Early-cycle cyclicals generate most of their returns early in the cycle (hence the name).
Don’t get sucked into the silly-verse
Importantly, in addition to the economic scarring of COVID and extreme demand surges triggered by Covid-inspired excess monetary and fiscal transfers, we contend that a malinvestment bulge/bubble has persisted for years in the U.S. and abroad, sucking in a considerable amount of capital from many sources. The malinvestment bulge/bubble’s roots reside in the unreasonably low cost of debt and equity capital going back to the earlier years of the 2010s. This has spawned a variety of new-age businesses and business practices residing extensively, though not exclusively, in the technology and new media realm, and served to inflate valuations in the broader marketplace and in particular for companies possessed of the right attributes and buzzwords to motivate this particular crowd.
For the moment, this is an internal thesis and not precisely “provable” – at least not provable in the way that Big-Short investors proved that 2007 vintage AAA-rated CDOs were not really composed of AAA credits. Nor is the downside case as extreme. But if we are generally correct that, let’s say:
- cloud infrastructure companies are really just hardware companies operating with a fancy name, or
- cryptocurrency trading platforms may just as well trade tulip bulbs, or
- far too many private equity sponsored businesses are over-levered and under-invested for longer-term viability,
Then there is still a lot of money to be made just staying far, far away from the silly-verse as economic conditions renormalize back to something rather 20th century, at least in terms of the real interest rate.
Our view is that the malinvestment bubble was not just a COVID-thing but rather a multi-year affair from years of deficient capital costs that fueled doe-eyed optimism about just how many disruptor businesses could be the next Google or Apple. This suggests there is more to come, with the stock valuation risks not driven by a higher academic cost of capital, but by basic funding challenges that expose “silly” business models and concepts as exactly that. That does not necessitate another 20-30% bear market leg, broadly speaking. Inexpensive stocks are not hard to find, and the further away one gets from the malinvestment bubble, the better the relative opportunities appear. The reader might not wholly agree on the scope and duration of the malinvestment bubble. However, highly levered businesses and those with a degree of dependence on easier funding conditions than will likely be the case for the next 1-2 years should suffer, as this is precisely what Central Bank policies intend.
A different way of expressing the same thoughts, is that after a long, roughly 14 year period from 2008 to 2022 where real interest rates and risk premia were held down by Central Banks globally using a variety of tools, it is unreasonable to expect the same prospectively. Part and parcel of the severity of the 2022 Bear Market is that it took a while for this to sink in to asset prices and financial participants were conditioned to expect a Fed-put or the International equivalent.
Late stage tightening cycles tend to disfavor the dollar
Stock market multiples entered the year at an “ok” level for the USA in 2023 and at much cheaper levels overseas, with the dollar at an elevated level versus longer-term averages and versus the U.S.’s own level of competitiveness, reflecting a favorable interest rate differential between the dollar and other major currencies. If the Fed is done raising interest rates early in 2023, as we expect, while other Central Banks keep at it for longer, the relative interest rate spread can become less favorable to the dollar, bolstering foreign currencies. There is some risk that foreign currencies may continue to be plagued by their own issues – such as fragmentation risks in Europe, high debt levels and poor demographics in Japan, and competitiveness in smaller currencies such as the Pound and Swiss Franc. But historically, an inverted yield curve suggests the dollar trades lower prospectively.
The debate will shift from the price of money to the quantity
For most of 2022 (and probably part of 2023), Central Banks will continue to focus on the price of money in the form of short-term interest rate increases. This only partially addresses the other component of the situation, the quantity of money loitering in the world’s major economies. It is enormous, at 83% of GDP in the U.S., 56% of GDP in Europe, and 188% of GDP in Japan. Money velocity (the rate at which money turns over in the economy) has varied widely over the course of modern financial history and has generally declined in the last 40 years (coinciding with the bond bull market). It is difficult to say what the “correct” values for monetary aggregates ought to be. However, in all the world’s economic regions, it is hardly a coincidence that inflation has blasted ahead after years of dormancy following a wild period of excess money creation during the Pandemic. If broad inflation is generally caused by too much money sloshing through the economy, a simple solution is to have less of it, and let that sink in. High interest rates will motivate debt pay downs as maturity walls hit. Pared alongside balance sheet contractions at the Fed, ECB, and other major Central Banks, this should be part and parcel of the financial weather for most of 2023, and possibly beyond.
This looks like it will take some time to reach a sustainable and non-inflationary level after 2 years of crazy…
If we are really in a durable value cycle, then the “normalization game” predominates
One final, let’s say, fox-ish thought, is to think through the change in financial ecology to one of investor psychology and “what works”. There is an old expression that growth is about projecting, while value is about normalization. If a statistical recession were to happen, it would include an old-fashioned inventory cycle recession, which by the way is something that has not exactly happened in the United States since the Gulf War in 1990. But it looks inbound - inventories are being burned down by manufacturers, retailers, and distributors rapidly, as demand has fallen for things like housing, while others fear being caught with unsalable inventories as consumption wanes. Inventories should reach bare-bones levels in the late spring at the rate this is unfolding, leading to far-reduced earnings risk than might be supposed in the latter parts of 2023. Normalizing earnings and margins for a climate when inventories are not being burned down is the correct value disposition. And it’s hardly a rosy projection under such circumstances. Projecting growth and big TAM penetration is a much different game, especially if the cost of capital shortens expected duration and finance ability.
Inventory growth has not yet reached a contraction but we expect it will in early 2023. This is usually a buy-signal for Industrial and Manufacturing stocks (inventories can only get so thin…)
Q&A – Some of the more popular questions I’ve received over the last few months.
Recession fears seem to be what everyone is talking about. Can the U.S. avoid such a scenario? If not, how bad could it be for the economy?
The steeply inverted yield curve is hard to ignore; it definitively predicts an economic slowdown or recession. One would be foolish to disregard the strength of this signal.
There is too much demand relative to the global supply chains’ collective capacity to supply it. These supply chains can adjust, but it takes time and it takes labor supply and labor flexibility to do this. The current labor supply is not sufficient, with 2022 unemployment ending the year at a new 50+ year low. Thus, to have enough excess labor supply, some businesses and jobs need to disappear, so that laborers can be reallocated. In a recession, jobs are lost and some businesses do not survive, so this is one possible path. We could conceivably go through a period of below-average GDP growth but not an outright contraction, and it would accomplish something similar. That said, corporate earnings growth would be weak in either scenario. From our perspective, it may not really matter very much which it is. Labor supply needs to be rebalanced, and weakening overall business conditions is the most expedient path to this.
The Fed noted in late 2022 that their labor market model has not worked as they thought it would following the Pandemic. Basically, the percentage of people in the 25-55 year old age cohort currently working and part of the labor force is back to 2019 levels. For people aged 55+, about 10-12% of those that were working in 2019 or earlier have stopped working, or about 3-4 million workers. Given the average age of this group, the odds that they will all come back into the labor force are not high. With high demand for all kinds of products and full utilization of the labor force, the economy has not been able to contend with this loss smoothly. The Fed’s toolbox for this situation is a very imprecise sledgehammer that will impact demand for both products where supply and demand are out of balance, as well as for many where that is not such a big problem.
Do you anticipate another leg down in the market?
That is the consensus view. Bull/bear sentiment indicators were at about 75-80% bearish to start the year, which is astonishingly poor. It is reasonable to think there will be some pretty dreadful earnings declines in a few places as the higher cost of financing bites. However, this is all widely expected. For the bear consensus to prove profitable, the “sticker shock” of poor earnings will need to be pretty bad…
Corporate earnings happen in nominal dollar terms, while statistical recession calculations adjust for inflation. At the market lows in October, the S&P 500 was down 26%, but this was with 9% trailing inflation. In real terms, this means it was down 35% - and that was with no recession or credit stress in the economy. We don’t know if the October 2022 low will be the final bottom or not. We would just be careful with excessive negativity (in terms of an absolute rock-bottom price target) as the nominal economy is still advancing. Bear markets in excess of 40% (nominal) are rare – there have only been 3 of them since World War 2.
Our view is to look at the market and the economy in parts rather than as a whole. The whole market might not be able to stay flat if earnings that are expected to grow don’t, and decline. But we think this problem is more pronounced in growthier names and companies that benefited from sustained ultra-low interest rates, such as housing and commercial real estate. The industrial backbone of the economy does not need to contract – it genuinely needs to grow but cannot until other parts of the economy free up workers. Overall, we see a case for a lot of physical economy businesses to get along decently while the digital economy and financed economy businesses lag.
Is there any case where a recession is good for stocks?
Given prevailing sentiments and labor shortages, if we have a recession, it might prove cathartic, just to get it over with. But one is hard-pressed to find prior recessions that were “good”.
Where is Cambiar finding opportunities?
As mentioned in the body of this piece, there are clearly opportunities in a variety of classic cyclical sectors given the “recession is looming” narrative. We would call out Industrial stocks serving manufacturing and transportation end markets as great examples of where the puck is going/has to be going over time.
Consumer-oriented stocks have been very tough since early 2021, when relative momentum and pricing peaked, with a variety of consumer durable and nondurable franchises earnings showing extreme volatility in response to a demand surge, a cost surge, procurement, and transportation challenges. We have a lot of sympathy for business managers at these companies – this has been a nearly impossible set of circumstances to navigate cleanly. However, after a punishing last ~18 months, a variety of consumer-facing businesses look to have demand trends back to or below their pre-COVID trends. A business trend and profitability normalization exercise suggest opportunities are emerging in this vertical.
We are also intrigued by opportunities in financial services and commodity businesses which have gone through similar (though more protracted) industry volatility. A high cost of capital and low to negative money supply backdrop is not intrinsically “good” for near-term fundamentals, but these are likewise interesting renormalization exercises.
The Cambiar domestic suite of products has performed well over 2022, what can you attribute this to?
Cambiar employs a relative value discipline in all of our investment strategies, which has helped to identify logical entry and exit points during the extremes of the COVID and post-COVID landscape. Given the rapid increase in the cost of capital over 2022 and the higher cost of capital that lower-multiple value stocks embed, hewing to this discipline was most critical. We also use business quality and capital discipline hurdles for all our investments, which means that within a value-stock universe, our holdings have higher than average profit margins and returns on capital with lower-than-average financial leverage. These attributes reduce operating leverage and financial leverage as sources of volatility, which helps in a rising cost of capital & recession-fearing marketplace.
Learn more about our domestic suite:
Cambiar Large Cap Value
Cambiar SMID Value
Cambiar Small Cap Value
As an average investor, what should we be doing?
The relevant Warren Buffett quotable right now is to be greedy when others are fearful, and be fearful when others are greedy. Embrace the fear and uncertainty of a Fed tightening cycle, and understand that the uncertainty of a “planned recession” is an asset that can be amortized, as opposed to an obvious reason to sell. Part of that thought also means not trying too hard to time the ultimate low in the market, which we seem to be getting a lot of client questions about. Odds are it will happen abruptly and not when you, or anybody on financial television expects.
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