As a reminder, this blog is an outlet for our thoughts, primarily on the macroeconomic environment, which contextualize our investments. Please subscribe via the form at the bottom of the page to receive future post notifications.
Has the macro environment ever been more chaotic?
We are hard-pressed to find historical examples of the events unfolding before our eyes. The 1970s post-Bretton Woods inflation is typically offered as a corollary, though that may be because it's the only inflationary bout most alive today have experienced. However, 1970s inflation was primarily a result of bank lending rather than fiscal deficits, and at the time, debt-to-GDP ratios were far lower than today. Low debt levels allowed Paul Volcker's Federal Reserve to sharply raise interest rates to slow lending and ultimately curb inflation. 1940s post-war inflation may be a better parallel, as World War II effectively acted as a shock to supply chains in the same way the pandemic has. Today and then, federal debt relative to GDP exceeded 100%, and any significant increase in interest rates would unsustainably raise the cost of carrying debt, forcing further easing from the central bank. In the 1940s, the Federal Reserve kept interest rates artificially low, and we'll discuss below why this is likely to occur again.
There's a New Sheriff in Town 🤠
Its ticker is CLc1, better known as the price of WTI crude oil. In August of 2021, we wrote extensively on the prospects of significantly higher oil prices due entirely to a supply-demand imbalance caused primarily by the Western world's stubbornly unrealistic clean energy transition timeline. We remind readers that oil cleared $100 a barrel before Russia invaded Ukraine; this is more than just "Putin's price hike." Runaway oil prices are central bank kryptonite, yet the powers that be appear intent on driving them higher in the name of climate change. Politics is standing in the way of rational action. We need to increase oil production in the U.S., at least temporarily, but that is not politically expedient for the current administration and, therefore, will be avoided at all costs. You can find U.S. Energy Secretary Jennifer Granholm laughing at the prospect of doing so here.
Fossil fuels are not just a political target; they've been at the forefront of a transformation within the investing community known as ESG – Environment, Social, Governance. There are now scoring systems that assign public companies ratings in each category, determining their inclusion in certain indices and investor portfolios. As a result, oil and gas companies have seen their access to capital all but dry up. In a March 2022 survey of 141 U.S. oil and gas producers, 59% said they were under investor pressure not to increase production. Perhaps most shocking is the fiscal response to high prices. President Biden has called for a gas tax holiday, and states such as California have passed direct stimulus measures to support citizens at the pump. Fiscal relief only exacerbates the problem by helping maintain demand that high prices would otherwise quell.
Higher energy costs are a regressive tax on the economy and a leading indicator of economic slowdown. Impacts are felt soonest at the pump for the average American, but lasting price increases will flow through every good and service in this country. A general rule of thumb estimates energy accounts for 30% of the cost of everything. Yet, we seem to be taking for granted the very thing that gives our world motion. Critically, energy prices need not move higher from here to have a material flow-through effect on prices, as retaining an elevated range will force each layer of the economy to adjust to a new normal rather than a temporary shock.
President Biden has attempted to court Saudi Arabia and the rest of OPEC into increasing global oil production (or, in other words, doing our dirty work), to which his calls have quite literally gone unanswered. It seems we'd rather learn the hard way, just as much of Europe has. Germany is a particular disaster. Prior to Russia's invasion of Ukraine, Germany sourced 55% of its natural gas needs from Russia. Meanwhile, the nation has been steadily decommissioning its nuclear power plants because up until recently, nuclear was not considered "green" in EU taxonomy, despite being the most reliable source of clean energy. Today, just three of Germany's nuclear power plants remain, all of which are scheduled to shut down by the end of the year. With Germany firmly in its grip, Russia has just cut natural gas exports to Germany by 60%. Almost comically, Germany has chosen to reactivate coal plants to help offset the gigawatt loss on the grid. The situation is so dire the government has resorted to rationing measures in an attempt to stockpile enough energy to last through the winter, with certain municipalities even limiting the supply of hot water to certain hours of the day. If supply-demand equilibrium is not restored in a timely manner, oil may be the global wrecking ball we all see coming but refuse to do anything about.
Powell's Poker Face 🃏
The Federal Reserve's inaction throughout 2021 may be remembered as the organization's most significant policy error. Despite a textbook set up for inflation (outward shift in demand, inward shift in supply), they chose to keep their foot on the gas pedal of easy money. Following the realization that inflation was indeed not "transitory," the Fed has been forced into hawkish policy in an attempt to regain credibility and rein in inflation. In our last post, we wrote central banks "cannot print oil, natural gas, base metals, grains, rare earths, or other core inputs across the commodity complex." Tackling inflation requires solving the supply/demand imbalance, and since supply is out of its control, the Federal Reserve has resorted to crushing demand via the negative wealth effect. Using the S&P 500 and Barclays Aggregate Bond Index as proxies, the traditional 60/40 portfolio of equities and bonds has declined 16% this year, and the supposed safe-haven U.S. 30-Year Treasury index has fallen nearly 23%.
By raising interest rates and tightening financial conditions, the Fed has re-rated nearly all financial assets, making Americans feel poorer in the hopes of curbing consumer demand. The stock market used to reflect economic fundamentals, but today it's being used as a tool to affect the economy. It's working. Severe declines in valuations and drying access to capital have forced many companies to switch from hiring to layoffs, specifically among higher growth technology companies, to reduce burn rate. Adverse shocks to consumer balance sheets amidst rising prices have deterred consumer sentiment, as the oft-cited University of Michigan Consumer Sentiment survey lodged an all-time low in June and remains in a downtrend .
Ironically, the Federal Reserve should most fear deflation, and at their current pace, that's what we'll have on our hands a year from now. In our heavily indebted world, falling prices make interest and principal payments more expensive in real terms. Debt becomes harder to carry, deteriorating the balance sheets of both firms and households and thus further dragging on the economy. The most important balance sheet is that of the U.S. government, which simply cannot default in nominal terms. It's precisely this concept that convinces us the Federal Reserve will be forced to pivot, and in relatively short order. The rising interest rate environment has substantially increased interest expense for the government on outstanding U.S. Treasuries; meanwhile, tax receipts look set to fall precipitously following a blockbuster 2021. The proxy shown below is the average of the Federal Funds Rate and the U.S. 5Y Treasury multiplied by public debt outstanding. The Fed has seized rate hikes in every case where interest expense rose dramatically in the last three decades. We expect this time will be no different. The Fed will eventually return to easing and increased asset purchases, monetizing federal debt to fund the deficit.
Bobbing for Apples 🍎
While market activity in 2022 has been about valuation reset in a rising interest rate environment, we believe the second half of the year will be driven by earnings revisions as the weakening macro environment impacts corporate profits. Many retailers have already indicated margin deterioration as inventory levels ballooned in the first quarter. For example, Walmart and Target's inventories rose 32% and 43%, respectively, as they had incorrectly extrapolated last year's high demand levels. This inventory was sourced at higher prices due to supply chain congestions and will need to be marked down to clear the shelves. In addition to the flow-through effect of higher energy costs, the U.S. dollar's recent strength will also be a margin headwind for the many multinational corporations that comprise the S&P 500. Roughly 30% of the S&P 500 constituents' revenue is international, which will be negatively impacted by a strong dollar, having appreciated against its main trading pairs, the Euro and the Yen, by 13% and 20%, respectively.
As the described Fed pivot unfolds, stabilizing valuation multiples should help offset market-wide earnings headwinds. We expect a market much more responsive to individual company fundamentals, as top-down macro factors eventually cede to bottom-up company fundamentals. Of course, some companies will perform better than others. Innovation continues to be our core focus, where companies are rapidly gaining market share, defining new markets with long growth runways, or more likely, some combination of the two. Here you will find the highest growth rates and, subsequently, long-term returns. The simple exercise below, where we assume a company is trading at some multiple of earnings (or revenue) today and grows at a given rate for ten years, illustrates the power and importance of growth in any valuation environment. Note the matrix represents the compound annual growth rate over the ten-year period.
Where might one find such growth in today's upside-down economy? First, it's vital to recognize innovation gains share during downturns. Businesses adopt new technologies to drive efficiencies, helping cut costs and fuel growth. The upcoming period will separate the need-to-haves from the nice-to-haves. Through the 2008 financial crisis, today's mega-cap tech giants didn't skip a beat, and in some cases, revenue growth actually accelerated while the global economy deteriorated around them. In 2009, the cohort of Amazon, Apple, Microsoft, and Google grew revenue by 33% on average while U.S. GDP declined 2.6%. Many pundits are quick to compare the recent valuation decline to that of the 2000 tech bubble and therefore forecast a long road to recovery for beaten down growth companies. However, the differences could not be starker. In the early 2000s, internet infrastructure was in its infancy, and scaling companies proved far more difficult than Wall Street projected. As a result, many dot-com darlings went on to fail or materially underperform. Today's technology platforms enable companies to reach global scale virtually overnight. We'll re-share a graphic from a previous post.
Successful investing is contrarian at heart. Historically, investors have been well-served to buy when no one else wants to and sell when everyone else can't get enough. The market can occasionally be irrational, but generally, it's a highly effective probabilistic machine discounting future events. Chances are if you have a concern about the outlook, it's already reflected in the price. 🐂
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 Dallas Fed Energy Survey. First Quarter March 23, 2022. Special Questions.
 Storbeck, Olaf & Sheppard, David. Germany Fires Up Coal Plants to Avert Gas Shortage as Russia Cuts Supply. Financial Times. June 2022.
 Chazan, Guy. Germany Dims the Lights to Cope with Russia Gas Supply Crunch. Financial Times. July 2022.
 Refinitiv Data.
 Refinitiv Data
 Target 10-Q Q1 2022 & Walmart 10-Q Q1 2022.
 Brzenk, Phillip. The Impact of the Global Economy on the S&P 500. S&P Global. March 2018.