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2Q 2022 Newsletter
From Ralph Segall, Chief Investment Officer
“When the facts change, I change my mind.”
—Attributed to John Maynard Keynes
In our last two quarterly newsletters, we have found ourselves grappling with questions about economic growth and valuations. In many ways, these questions seem to be of the age-old variety: are we at the top of the business cycle and, more important to us and our clients, are we on the verge of a bear market? The topic of business cycles is not discussed much these days. In most academic—and policy—circles, it is thought to be something of a relic that happened in the bad-old-days when economic “science” was not as well developed. It may be even more rare that we at SBH speak of bear markets, given our genetic predisposition to avoid such lofty macro topics!
This is the first time in over 27 years we have offered an economic forecast. We are doing so to mark what we believe is the end of a major business and market cycle. Ends of cycles typically occur to resolve an excess in the system, i.e., “too much” of something. All one must do is recall the subprime mortgage crisis of 2008-09, when the “too much” was of subprime mortgages and over-stretched housing prices. Twelve years later, where are the excesses? We are calling this round of excess the “Three Too’s.”
1. Too Little Growth in Global Income, which cannot support…
2. Too Much Global Debt,1 as the aftermath of the last crisis was never resolved, but just pushed down the road, and as a result, we have…
3. Too High Valuations in the financial markets as neither stock nor bond prices can be justified, particularly given the first two Too’s.
Let’s briefly summarize these points and what they mean for portfolio expectations in the next several years. You might be wondering about the effects of the Russia-Ukraine war or other current issues of the day—the reopening of societies as COVID continues to transition from pandemic to endemic, the global supply shortages, and inflationary pressure. In the “Three Too’s” framework, they can be thought of as accelerants or retardants to how long it may take economies and markets to work through the downside of this cycle. No one can forecast how these issues will ultimately be resolved, but by assessing them and other developments within this framework, we can get a better sense of when the upturn in the next cycle may occur. Just as surely as business cycles and bear markets end, the downturns that we go through sow the seeds of the next recovery. There is another silver lining in this forecast, too, but that comes at the end.
1. Too Little Growth in Global Income
Growth in any country’s economy is the result of population growth (births minus deaths and net immigration) and productivity growth. Nothing more, nothing less. Around the world, overall population growth is slowing as fertility rates fall. In particular, the age of the global workforce is beginning to decline as the post-WWII population ages into retirement. The disruption of COVID has caused a drop in the labor force, too. It is not unusual in history to see labor force declines in the aftermath of a pandemic. This is a long-term issue that will not be easily resolved. Productivity declines, on the other hand, will be transitory, to an extent. One of the factors undergirding growth for the last 30 years was the increased role of globalization in trade, a trend aided and abetted by the maturation of the Internet to a material degree. The disruption of the “supply chain” seemed to be just another (resolvable) byproduct of the pandemic, but the outbreak of hostilities in Eastern Europe may cause that rupture to become permanent. Whatever one’s political views on this topic, national interests and less emphasis on globalism will lead to less efficient production. In the interests of safety and security, more countries will attempt to ensure more of their needs are met by homegrown product as opposed to cooperatively relying on other countries’ unique specialties through global trade.
As a result, countries will be obliged to invest resources to be self-reliant. This will take time, capital, and effort, all to no current return on investment as the build-out and ramping to scale takes place. Second, and more profound, is the consensus that has formed regarding the need to convert from fossil fuels to alternative sources for generating heat and electricity. While there will be a period in which massive amounts will be spent, it will take a long time for countries to realize efficiencies from these alternative sources. Think of how many gas stations will close in the next 10 years and ask yourself how running electrical lines through major urban areas to supply them with power will be achieved. Private equity managers speak of the “J-curve,” a period in which the outlays for a new initiative generate losses before the returns are produced. The global economy is going to experience such a J-curve too, both in protecting national interests and decreasing the role of fossil fuel.
Finally, global growth is going to be damaged by China’s lingering issues with the aftermath of a 30-year period of rapid growth that was largely driven by real estate financed with government borrowing. The West may have built too many homes in the subprime crisis, but China has built too many cities, many of which stand essentially vacant. The aging of their population (their median age has exceeded that of the U.S. since 2018) only compounds the issue. Official forecasts for 2022 economic growth in China are 5.5%, a rate that is considerably lower than it was as recently as several years ago. Growth has also been severely affected by Chinese policy errors in treating COVID and the poor results of their homegrown vaccines. Growth has stalled because the government took draconian regulatory measures towards rapidly growing technology companies to ensure they adhered to the party line. This government clampdown will have lasting effects on both entrepreneurs and western capital for years to come.
2. Too Much Debt
We have previously covered how much debt was issued in the wake of the subprime crisis of 2008-09, and that paying down that debt in the following years was never fully addressed. When COVID hit, there was no alternative but to issue more and more debt. Permissive monetary policy to forestall the effects of the pandemic only made matters worse. Yet interest rates continued to be suppressed, keeping the debt burden at bay. However, the emergence of inflationary pressures as more than transitory has forced the hand of central bankers around the globe who will now be obliged to raise rates far more than they, or the markets, contemplated. Further, more rounds of government spending to be funded largely by debt seem very unlikely at this time as does the possibility of tax increases. The use of monetary policy as a tool to keep the economic balloon inflated has largely been removed from play.
3. Too High Valuations
Whether we are considering equities or fixed income, valuations on global financial assets are at or near historical peaks. Interest rates began 2022 near zero in the U.S. and below zero for government debt in Europe and Japan. This was not only well below the real growth of those economies, but it was also increasingly negative after factoring in the impact of inflation. Consider the 10-year U.S. Treasury at quarter-end, which yielded 2.3%.2 For the last 12 months, inflation, as measured by the CPI, had risen 7.9%, which meant that the 10-year Treasury was producing a negative yield of 5.6%.3 For many investors, this was tolerable because one could allocate more and more to equities to make up for the shortfall.
On many valuation metrics, however, current equity valuations are anything but cheap, as shown in the table below.
These valuations moreover assume robust earnings growth. A survey of Wall Street strategists at or around quarter’s end estimated that profits would increase by 9.3% in 2022.2 Those forecasts must be at risk due to higher labor costs than forecast, higher costs of raw material inputs, higher costs of freight movement, and higher interest rates. As a result, we believe the Equity Risk Premium4 used to value stocks will be higher than expected in the coming periods.
Looking Ahead: Portfolio Expectations
In the Bible (Ecclesiastes 3:1), we are told that there is a time for every purpose under Heaven. We may be at the end of a time to grow capital and may now need to focus more on protecting it. We think clients may need to assess how much of a decline their portfolio could absorb without interfering with its purpose—providing a flow of spendable cash, whether now or in the future—using reasonable (i.e., not based on returns of merely the last decade) long-term return assumptions. This is a job for you and your portfolio manager.
It might seem strange to say, but this market transition is what excites us. These are the times when we shine for our clients because our approach of preserving capital in down markets has served our clients well over more than a quarter century. These challenging market conditions will last longer than the three-month “Bear Market” of 2020 but this will not be the end of good times forever, either. As we noted at the beginning of this essay, the bear market’s purging of excesses creates the conditions for a new bull market to follow. This is an important point that deserves emphasis.
Second, from our perspective, we will pay close attention to asset allocation and how we protect client capital within those categories. Whether that calls for fixed income holdings to carry less interest rate risk or higher credit quality, or by holding equities that have the best and strongest positions or prospects in their industry. It is here that our long-standing approach to investing—buying individual securities based on their potential, valuation, and risk profile—will be a far better approach than owning a basket of holdings, not all of which can be subject to the same scrutiny we provide. As my first boss always drummed into my head: it is not a stock market; it is a market of stocks, and there is always an opportunity to be found.
Last, our work on long-term returns from the U.S. markets reminds us that while bear markets have occurred periodically, over the long term, the capital markets have provided attractive real returns (above 5%) most of the time. To arrive at this conclusion, we broke down the now 96-year period into sub-periods that include varying shorter periods. Some were time-based, like decades, while others were situational, like periods of economic growth or decline, of rising or falling interest rates, and so on. For each of these sub-periods, we measured the “batting average” during that period, which was the number of years in that smaller period a return greater than 5% adjusted for inflation (a real 5% return) was achieved. In every such sub-period, the batting averages were all above 50%. Only in bear markets was the rate under 40%. The good news is that bear markets were the shortest sub-group in our sampling. The second piece of good news is to remember that in baseball, achieving your goal even 3 out of 10 times is considered a mark of success.
Speaking of baseball, the new season is upon us. Let us end this note with the words of the retired Hall of Fame broadcaster for the Chicago White Sox, Ken Harrelson. At crucial moments, the “Hawk” would always intone, ”OK boys, time to cinch ‘em up and hunker down.”
Statistical support from SBH Quantitative Research Group (especially Tom Dzien) is gratefully acknowledged.
1Both items 1 and 2 were the subject of our fourth quarter 2021 newsletter.
4The term equity risk premium refers to an excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing.
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.