Thoughts on the Current Environment
Second Quarter 2023
by Ralph Segall, CIO
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“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”
—Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 1841.
Over the course of the past year, we have written about what we have called “Regime Change” to describe the end of an era when central banks around the globe kept interest rates at near-zero levels. The change began in early 2022, with a series of interest rate increases by the Federal Reserve (Fed). These consistent quarterly interest rate increases were felt almost immediately in the stock and bond markets, both of which registered what were among their worst calendar year returns in the last 100 years.
It has been a matter of debate as to whether these rate increases will lead to a recession, either in the U.S. or globally. Our position has been that we do not know if a recession will ensue. If one does take place, however, we have had the view that it will be worse for Wall Street (i.e., financial assets) than for Main Street (i.e., the real world economy) because we do not think organizations will experience the level of layoffs similar to prior downturns, such as 2009 or 2002. For Wall Street, we believe the valuations of stocks and bonds will be impacted by the process of recalibration to an era of higher interest rates and slower growth in corporate profits.
It Was Just an Old-Fashioned Bank Run
Rising rates are also causing unexpected challenges, such as the most significant financial and economic development of the first quarter—the failures of Silicon Valley Bank and Signature Bank. As has been covered extensively in the popular and financial press, both institutions failed not so much because they held “bad” assets whose value had dissipated but because of an inability by the banks to remain solvent to meet the demands of depositors for cash. In other words, they failed in an old-fashioned run on the bank. This old-fashioned failure was precipitated by new world technology, social media, and the smart phone. One other bank, First Republic Bank (which, as of this writing, had not failed) seemed to be a bit like the “Bailey Building & Loan” from the 1946 movie, “It’s A Wonderful Life.” In the film, they withstood a depositors’ run by paying back all but the last $2.00 in the vault by closing time. In the current world of electronic transfers occurring at all hours of the day, that notion seems quaint, but the point here is the same: the fallacy of fractional banking. All depository institutions remain solvent only because all their depositors do not demand their money at the same time. Were that to happen to any bank, it would fail.
Some commentators have proposed that the closures of Silicon Valley Bank and Signature Bank will be the triggering event for a recession. As we have seen with the war in Ukraine, supply chain issues, deteriorating geopolitical relations, and trade restrictions, we believe these bank failures will likely merely accelerate or retard the process of economic adjustment precipitated by the Regime Change in interest rates. Given the 15-year period of near-zero interest rates, we believe a material amount of economic players have never experienced or managed in a rising rate environment, such as investors in cryptocurrencies, investors in venture capital, bank officers who have never paid much for deposits that seemed to accumulate without effort, investors that subscribed fully to the mantra “buy the dip,” and central bankers who thought for far too long that inflation was transitory. They all underestimated the risk of inflation and its impact on the cost of capital.
The Impact on the Real World Economy
In this light, the concerns about banking safety and security signify to us that the re-adjustment process is beginning to spill into the real world part of the economy from the financial market part of the economy. We anticipate borrowers are going to be more cautious about undertaking fresh obligations and bankers are going to be more cautious about providing those borrowings. Many venture capitalists will find themselves unable to finance their development efforts and will have to cut back to conserve cash. Even the large, high-tech firms that boomed during the period of cheap money are falling prey to this thinking, as many of them have announced layoffs. It remains to be seen if it will be limited to high-tech companies or if high-tech is merely the entry point of a trend that will spread to other sectors in the economy.
Irrespective of whether a recession ensues, we believe investors face a dilemma in the near term. If inflation has become entrenched, interest rates can be expected to stay higher for longer, which will keep a lid on bond prices and stock market valuations. Alternatively, if inflation abates, because companies and labor cannot make announced price increases stick, profits are going to be under pressure. Less inflation means top-line revenues will grow more slowly. Operating rates will be lower, and many costs will prove to be sticky on the downside—think wage increases already granted or higher interest charges.
The Forces Keeping Inflation at Bay
In the longer term, there are several forces at work that suggest to us that inflation will be kept at bay. This may turn out to be a Pyrrhic victory, just to be clear. They are technology, debt, and demographics.
Technology, it must always be kept in mind, is deflationary in nature. Allowing a product or service to be delivered at a higher quality, with less frictional cost, be it time or space, means that its creator can provide a better value for the cost. This obliges the competition to lower prices to compete. In other words, technology = lower cost = deflationary pressure.
Second, debt is deflationary. Money borrowed is used to pull the demand for some resource to today instead of consuming resources tomorrow. The borrower will be required to divert income earned tomorrow to pay back the money borrowed today to consume something today (think: a home that will last for 30 years).
The third factor is demographics. Globally, the rate of increase of the human population is and has been slowing at a much faster rate than most demographers expected. The size of the global human population is expected to stabilize far earlier than almost every forecaster expected. Most of this is a persistent decline in the fertility rate. Many societies are well below their “replacement rate” (i.e., the rate at which the population of a society stays constant). In fact, in several developed countries, the rate is dipping low enough to pose serious consequences. The population of Japan, for example, has begun to shrink. China is aging far more rapidly than forecast, as the consequences of Mao’s “one child” rule in the 1980s work their way through the population. In virtually every country in the world, the fertility rate has been in steady decline in recent years and shows little sign of an upturn. As the commonly accepted reasons for a decline in the fertility rate are family income and female educational levels, it is unlikely this trend will change any time soon. Depending on how much restraint any of these trends exert on growth, we believe expectations for the growth of corporate profits have to be correspondingly tempered.
Investing in a Slower Growth Environment
In a world in which growth is likely to be slower and the cost of capital is re-normalizing to a higher level, a question remains: how do we want to invest client capital? At this point, it is important to pause and restate something very important that all the strategy managers, the analytical teams, and portfolio managers in the firm agree upon: we believe that successful investing is built on the application of fundamental research to identify companies that generate above-average profitability in a consistent way and to consider the risks associated with making these investments with the goal of making sure that clients’ capital is being compensated for taking the risk of investing. The philosophy and processes we use will not change. We know what has been instrumental in helping our clients achieve their objectives and see no reason that our tried-and-true approach will not work as well in the future as it has in the past. We are aware that this is a time in which we might see the kinds of opportunities in which we have invested in the past coming from sectors or parts of the economy we have not considered extensively in the past. The game, in short, is changing.
Market Barometer
April 2022 to March 2023
Source: FactSet. Past performance cannot guarantee future results. All investments involve risks, including the potential loss of capital. One cannot invest directly in an index.
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