- Chip Rewey
Not Like Any Recession I’ve Seen
I grew up near Detroit, in a family and a city dominated by the automotive industry. I clearly remember the “double-dip” recessions of 1980-1982, the 1990 recession, and of course the 2001 recession post the “irrationally exuberant” internet bubble and related consumer gorging. The ’Great Recession” of 2007-2009 came post a period of financially induced excesses in housing, and a slowdown in demand that ended up reshaping and redefining what the U.S. banking system would look like going forward from a capital and risk perspective.
The commonalities of all the recessions, except the brief Covid plunge in 2020, were marked by softening demand, soaring unemployment and rising bad credit, while industrial conglomerates scrambled to stimulate demand with offers like $5000+ discounts on automobiles.
Don’t Fight the Fed?
Clearly the aggressive Federal Reserve actions to raise Fed Funds rates 300 basis points since March 17th has driven down equity values as investors brace for what they see as a coming recession. While we are not recommending “fighting the Fed”, we wonder what sort of recession the economy could face in late 2022 or 2023, and similarly wonder has most of the damage already been done to equities?
What Is Different This Time?
In our view, there are several aspects of the current economy and capital market structure that do not rhyme with the set-up for the recessions of 1980-1982, 1990, 2001 and 2007.
1. Employment is robust. US employees on non-farm payrolls rose 315 thousand in August and have risen 3.5 million August YTD. Moreover, average hourly earnings are up 5.2% August YTD. Incredibly, the Bureau of Labor Statistics job opening survey, JOLTS, showed 11.23 unfilled jobs in the US as of July 31st.* Too few people to fill too many jobs is not like any recession we have seen.
2. The Supply Chain Crunch and Demand: Demand for many industrial and durable goods continues to far outstrip supply. Driven by Covid lockdowns, remote work, labor shortages, a Just-In-Time supply chain that has gone Just-To-Far, most industrial companies we speak with all report healthy demand, if not rising backlogs, but sales weakness due to the inability to get parts to meet demand. These shortages have left finished goods inventories for many goods are at extremely low levels, and have driven prices higher, as strong demand and weak supply typically does. We have never seen automobile dealers able to price thousands of dollars over MSRP – but lean inventories of cars have left those in critical need of a car little choice but to pay up. Thus, we expect industrial sales and earnings to remain stronger than in past periods of Fed tightening, as record backlogs are delivered, and retail inventories are rebuilt. Since inventory levels are lean as we enter into a potential slowdown, we think we are less likely to see massive discounting to move bloated inventories. Strong Demand and weak Supply is not like any recession we have seen.
3. Reshoring: We believe its real and could likely bolster the industrial sector through a potential slowdown. Most companies we speak with are fed up with extended overseas supply lines and are taking action to build up their domestic production footprint. Indeed, several companies we have spoken with have acknowledged new reshoring contracts that will begin over the next few months. The passage of the CHIPS and Science Act on August 9th further bolsters this trend with $280 billion marked for U.S. research and investment over the next few years.
4. The U.S. Banking system is very healthy. The capital restrictions imposed on U.S. banks post 2007-2009, notably an 8% Tier 1 capital minimum, have dramatically altered the position of bank balance sheets into a possible slowdown. This fact was, in our view, proven in the Covid crisis, where banks were called upon to lend Paycheck Protection Funds (PPP), to literally save the U.S. economy from a crash. This is in stark contrast to 2007, where low capital levels and bad loans forced a government bailout of the banks.
Bank credit also remains pristine. As banks were forced to build equity over the last decade, they necessarily improved their credit standards and walked away from the riskiest parts of the credit markets, such as middle market high-yield leveraged lending – which is now dominated by hedge funds and private equity. Further, accounting standard changes by the FASB, specifically Current Expected Credit Losses or “CECL”, have further built reserves on current bank loans, likely mitigating future capital hits if credit does weaken. With strong balance sheets, a healthy credit picture and rising interest rates to bolster income, the banking system doesn’t look like a cause of major concern if an economic slowdown develops.
5. The rise of ESG and Activism: Since the last recession in 2007-2009, there has been a dramatic rise in the role of the investor on company managements. Governance, the G in ESG, has amplified the actions and accountability of management teams and their capital allocation decisions. While this pressure is hard to quantify, it has in our view led to less leverage, more capital return to share holders and fewer over-priced and risky acquisitions. Likewise, the rise of activism has provided the “stick” to the ESG “carrot” as management teams that do not undertake prudent capital allocation decisions are more likely to face board challenges, or even take-over offers, if equity valuations continue to lag intrinsic value levels.
What Do These Differences Mean?
Should You Sell Now? What Do Current Stock Sales Protect Against? The market averages have rapidly priced in a macro view of a U.S. slowdown/recession. Investor fears about the impact of future Fed hikes, in our view, continue to rattle the market, negatively impacting investor sentiment, and pressuring stock prices. But, we ask, what does a sale today protect against? The market has likely discounted a severe recession that is yet to rear its ugly head. While we don’t dispute that the impact of higher rates will slow the rate of economic growth, we are not convinced the outcome of this hiking cycle is a deep recession.
While soft landings are hard to achieve, our view of the economy is one where growth slows to level that allows the inconsistencies of the labor market and the supply chain to normalize. This normalization should naturally slow inflation, or pricing power, as Supply rises and Demand moderates. If you truly have a long-term investment outlook, current valuation levels may present more opportunity than risk.
What To Own Now?
Fed funds rates of zero percent never made sense to us for the long term, and our investment strategy has been to buy and hold companies that can tolerate, if not prosper, in a period of increased pricing power and higher interest rates. Conversely, we still see likely weakness in companies with negative earnings and cash flow, or with large levels of debt on their balance sheets. These are the factors that we see struggling in a higher rate environment. If management needs to raise equity to pay down debt or subsidize periods of negative cash flow, equity valuations would likely suffer. Even many “Unicorn” growth companies continue to look vulnerable, as negative cash flows will likely lead to reduced equity values under discounted cash flow models, due to higher interest rates used to derive present valuation targets.
Buy Low/Sell High
Investor fears have driven down the stock prices of many good companies, where the factors of a strong balance sheet and long-term growth prospects remain unchanged. With market averages already down considerably, and multiple individual company values down dramatically more, we recommend asking the question “what am I trying to protect from?” before you sell. While its never easy, building the conviction to buy good companies at low valuations, versus selling into fear, is a path we all want to take.
*Change in Non-Farm Payrolls and JOLTS data sourced from the Bureau of Labor Statistics, via Bloomberg.
This material is for informational purposes only and is not a recommendation or advice. Investments and strategies mentioned are not suitable for all investors. Opinions are based on current market conditions and are subject to change. No one can predict or project performance, and forward-looking statements are not guarantees. Past performance is not indicative of future results. Investing involves risk, including the loss of principal.