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It’s complicated

August 12, 2022

By Michael Kayes, CFA Charterholder

 

The older and hopefully wiser I get, the more questions I have.  I’m not sure why it seems to work that way, which I guess is a question in itself. So here are some of my questions about the economy and markets.  Is the economy in a recession, heading toward recession, in a “growth recession,” or is it just slowing?  It depends on how one defines a recession, and how one defines a recession depends on one’s political agenda.  It seems to me we are over-complicating this, but that is a common theme nowadays.

Is inflation heading higher or lower, and how long will it take before inflation gets to a level which will allow the Fed to stop raising interest rates?  The Fed has finally admitted that it has been wrong on inflation, so it is hard for me to believe they will achieve their target of 2% inflation any time soon, especially without doing meaningful damage to the economy.  The dual risks are that the Fed raises rates too aggressively and pushes the economy into a recession, or they stop raising rates too soon and inflation remains high.  In a nutshell, this is a difficult balancing act and my confidence in the Fed is low.

On the bright side, the consumer is in relatively good shape.  The wealth effect from a strong housing market, the bull market in stocks from 2009 – 2021, (this year’s correction notwithstanding), consumers have ample spending power to drive the overall economy.  Inflation erodes this purchasing power, but so far, the consumer has largely taken it in stride.

Will President Biden make it until the end of his term?  At his age, two years is a very long time, especially given his health challenges.  I would not be surprised if he steps down before the end of his term. How would the market react to a transition of leadership from Biden to Harris?  If it moves us closer to divided government and political gridlock it might be a positive catalyst for stocks.

There is an increasing focus on corporate earnings as we begin to look toward next year.  Will earnings grow faster than expected in 2023 or slower than expected? Critical question, but not easy to answer, unfortunately.  Companies across all industries and sectors are scrambling to cope with, and take advantage of, all the issues related to supply chain disruptions, the worst inflation in 40 years, ongoing political uncertainty, and the distortions and inefficiencies of crony capitalism.  What does this all mean? Most importantly, it means that the gap between the most successful companies and their peers is likely going to widen.  This dynamic will impact most industries and sectors.  In general, successful companies will have to do the following:

  1. Manage costs effectively in the context of the highest inflation rate in four decades
  2. Maintain or expand pricing power in an ever-changing inflationary environment
  3. Develop adaptable supply chains while adjusting to geopolitical risks
  4. Adjust to political pressures without losing focus on core competencies
  5. Continue to drive innovation in all aspects of their business

Each one of these critical success factors is multifaceted and dynamic.  The days when a rising tide lifts all boats is long gone.   My sense is we will see multiple companies stumble resulting in earnings disappointments.  This may also lead to a wave of mergers & acquisitions, as companies search for inorganic opportunities to grow, should their core businesses stumble.  Companies that nail each of these 5 factors will likely be huge winners in their respective industries.

The last area where there are important questions to ponder is valuation.  Price/Earnings multiples generally expand when earnings growth is accelerating, and when interest rates and inflation are low and relatively stable.  P/E ratios generally compress when the opposite takes place.  In a nutshell, that is why the stock market is down so far this year.  But, can this reverse sometime before the end of the year?  If inflation does start to move lower, the Fed might declare victory, and interest rates might actually decline a bit.  This might be a positive catalyst for a year-end rally in stock prices.  This all assumes that earnings growth resumes, the economy avoids a recession, and the interim election goes a certain way…  It’s complicated.  I wish it wasn’t, but it just is.

 

Michael Kayes, CFA

 

Exencial Wealth Advisors is an SEC-registered investment adviser. Any references to the terms “registered investment adviser” or “registered,” do not imply that Exencial or any person associated with Exencial has achieved a certain level of skill or training.

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