Thoughts on the Current Environment by Ralph Segall, CIO
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A Minsky Moment refers to the onset of a market collapse brought on by the reckless speculative activity that defines an unsustainable bullish period. Minsky Moment is named after economist Hyman Minsky and defines the point in time where the sudden decline in market sentiment inevitably leads to a market crash.1
The financial markets continue to reflect the consequences of “Regime Change,” the name we have given to the end of an era of very low (near zero) cost money. Over the summer, the stock market rallied as it tried to convince itself that two 75 basis point increases by the Federal Reserve (Fed) would surely be sufficient to stall inflation and allow the old game to resume. As the summer drew to a close, news that the Fed was actually going to begin Quantitative Tightening, a phased reduction of the massive portfolio it acquired to support low rates, brought the stock market rally to a screeching halt.
There’s an Elephant in the Room. What Does it Mean to Global Economies?
Most commentators focus on current issues—the war in Ukraine, the pandemic, supply chain issues, energy costs—in developing their outlook. Irrespective of these issues, there remains an elephant in the room that the global economy must confront: there is more debt outstanding than global economies can comfortably service. Why is that? The global economy endured two major financial crises in a very short period, first the subprime mortgage crisis in 2008 followed by the COVID pandemic in 2020. Between these two crises, governments amassed an incredible amount of debt to stimulate and support their respective economies. The stimulus provided by this borrowing, which policymakers turned into money, ultimately went too far. The excessive growth in money unleashed the inflation genie. Inflation is like kryptonite to central bankers. It is the one thing that can force their hand and cause them to change policy.
As a result, a peculiar state of affairs has developed where interest rates in the U.S. are heading higher even as the rest of the world struggles economically. Europe is on the brink of a major economic decline, largely inflicted by not just higher energy costs but by the risk of actual loss of energy resources as the result of the war in Ukraine. Neither the citizenry nor businesses can afford coming energy bills, likely leading to social upheaval, which has the potential to be fierce.
It may be worse in China. We in the West may be familiar with what happens to the middle class when a real estate bubble funded with debt finally bursts (see 2008), but probably not on the order of magnitude of the Chinese version of the story. The Economist recently estimated that 70% of Chinese household wealth is held in residential real estate.2 Add to that a policy response to COVID which has seriously suppressed economic activity and income generation, and one has the recipe for another society at risk. China’s response over the last 30 years to any perceived slowdown in internal growth has been to export more. This time around, Europe is not likely to be a big buyer while the U.S. has put up such high tariff barriers that we are not a likely source to absorb exports.
The capstone to these global economic woes will be the focus on climate change that is moving into high gear globally. While there will certainly be positive benefits down the road, the transition from fossil fuels to clean energy is going to be costly and will act as a drag on economic activity for years to come. In the last newsletter, we referred to the “J-curve,” a term used in private equity that refers to the drop in profitability an enterprise incurs as it makes investments to position itself for future growth. The “private equity” venture that is the global economy is commencing such a phase. Costs will be incurred that will (hopefully) pay off down the road, assuming all goes according to plan. In the interim, however, the benefits (be they incremental profits or tax receipts, which flow from profits) will be subdued and this will limit the ability of policymakers either to initiate new programs or respond to new crises.
While the U.S. economy may be in better shape than many other countries, it may still endure a recessionary period that is “okay for Main Street, but bad for Wall Street.” Think about it this way. If inflation subsides sufficiently that the Fed can ease up on its tightening policy, it will suggest an economy that is sufficiently weak to put corporate profits under significant strain. This would threaten not just stock prices, but corporate debt prices as well due to deteriorating credit standards. Conversely, if a stronger-than-expected economy keeps inflation high, interest rates will continue to move up as the Fed fights inflation, which will hurt bond prices and keep pressure on price-earnings (P/E) ratios. The regime that is changing took decades to build. The old model saw capital gain at the expense of labor, changing allocations of the “economic pie” that is gross domestic product from historical levels.3
The Emergence of the New Growth Model
Whatever emerges as the new growth model will be driven by different factors and its emergence will not happen overnight. But one thing is likely. The share of the pie going to capital—interest, rents, and profits—is not likely to go back to recent levels. That old regime is gone. Our task as stewards of clients’ financial assets is to assess how the game plays out against a less-than-pleasant backdrop for financial assets—bonds and stocks—and to position client accounts accordingly. The issues are laid out in the two charts that follow.
The first is a chart of yield curves at various dates over the last 40 years, covering the bull market in interest rates and marking both the high and low points for interest rates both on cash (Treasury bills) and long-term notes (the 10-year Treasury). While it might appear that the Fed has taken rates up quite a bit in 2022, the reality is that interest rates are still well below the median yield curve on the graph. Were we to plot such a graph in real (inflation-adjusted) terms, that is, subtracting inflation from nominal yields, we would see that real yields at current levels are strikingly low by historical standards.
U.S. Treasury Yield Curves
Since June 1, 1981, when Fed Funds rate peaked at 20%
20-year rates prior to 1993 are derived using linear interpolation of the 30- and 10-year Treasury notes.
Source: Segall Bryant & Hamill Quantitative Research.
The second chart relates real interest rates with price-earnings ratios. Market strategists comment on the level of P/E ratios to express their view on whether the ratios are too high (suggesting shares are expensive) or too low (suggesting shares are cheap). All such pronouncements are based on an assessment of various factors, but it appears that P/Es are quite sensitive to real interest rates. Between these charts, we can infer that bonds do not appear cheap, and shares may be in the same boat.
MSCI U.S. Forward P/E vs. U.S. Treasury 10-Year Real Rate*
January 2003 to September 2022
*As defined by inverse TIPS 10-Year.
Looking Ahead: Who Wins in the New Growth Model
In an economy where opportunities to grow profits are now reduced, the winners will be the strongest and best companies in their respective industries or sectors. The focus of our approach to equity investing starts with the identification of companies like that, ones that have the attributes—strong management teams, strong balance sheets, etc.—to thrive. One key will be to identify companies where the operating environment of the last 15 to 20 years (downward raw material and labor cost pressures, globalization, cheap and abundant financing) has materially changed—for better or worse. For some, it will be a new opportunity, but for others, a calamity. For others still, it will be a distraction of no consequence.
We also believe that companies possessing strong—and growing—free cash flows (defined as profits with depreciation added back and maintenance capital expenditures taken out) could well attract investor interest as being a source of cash flow by returning capital to shareholders. Indeed, one aspect of the recently signed Inflation Reduction Act is a newly created tax on corporate share buybacks. This tax could induce companies to focus on dividends as opposed to buying back their shares, perhaps in the form of “special” dividends above and beyond the normal payout. We are not suggesting we focus on companies with high yields but rather on companies whose prospects will produce an above-average growth rate of the dividend.
For us, watching, analyzing, and evaluating companies will remain our task. We have been working at this assignment for almost 30 years and we keep learning each and every day.
October 2021 to September 2022
Source: Bloomberg. Past performance cannot guarantee future results. One cannot invest directly in an index.
1 Source: Investopedia.com; definition provided by Akhilesh Ganti and updated July 27, 2022.
2 China’s Ponzi-like property market is eroding faith in the government, The Economist, Sept. 12, 2022.
3 This topic was covered in the 4Q 2021 edition of this newsletter.
Updated October 1, 2022. This information has been prepared solely for informational purposes and is not intended to provide or should not be relied upon for investment, accounting, legal, or tax advice. The factual statements herein have been taken from sources we believe to be reliable, but such statements are made without any representation as to accuracy or completeness. These materials are subject to change, completion, or amendment from time to time without notice, and Segall Bryant & Hamill is not under any obligation to keep you advised of such changes. This document and its contents are proprietary to Segall Bryant & Hamill, and no part of this document or its subject matter should be reproduced, disseminated, or disclosed without the written consent of Segall Bryant & Hamill. Any unauthorized use is prohibited.