The Facts Are Getting in the Way of a Good Story - Why Are Investors Fighting the Fed?
The week of February 13, 2023 brought economic data that should lead investors to question what we view as the prevailing market sentiment that the Fed is nearly done raising rates and could begin rate cuts before year end.
· January month/month CPI at 0.5%, the highest level since 6/30/22
· January Retail Sales +3%, the highest level since 3/31/21
· Capacity Utilization at 78.3%, consistently over 78% since 8/20/21
· January month/month PPI at 0.7%, the highest level since 6/30/22
Despite the Fed raising rates eight times since March 2022 to an upper bound of 4.75%, the economy seems to be re-accelerating to start the year. We wrote on 9/27/22 that the current economy is “Not Like Any Recession I’ve Seen”, and we believe this view remains valid so far in 2023.
In our view, there are several factors powering the economy that should persist through at least the first half of 2023, if not longer. These include:
· The massive spending provisions and tax offsets in the (poorly named) Inflation Reduction Act of 2022.
· The $1.2 trillion in spending that is just now starting to flow from the Infrastructure and Jobs Act signed into law November 15, 2021.
· The continued need for U.S. industry to back-fill pent up consumer demand that was deferred during Covid, and the need to rebuild finished goods inventories. We have seen the early company reports from 4Q22 earnings calls continue to reinforce this trend.
· The urgent need to rebuild the domestic manufacturing. Covid induced supply chain shortages highlighted that the past trends of globalization and just-in-time inventory strategies have left the U.S. critically short in the ability to produce goods and resources. From our conversations with companies, reviewing earnings calls and conference presentations, we believe corporate America is serious about rebuilding at least some part of its ability to manufacture in the U.S.
· Labor shortages: The December 2022 U.S. job openings of 11.01 million, in our judgement, stands in stark contrast to recession levels (such as the 2.487 openings in September 2009). U.S. companies are still competing for workers, still raising wages and still having to curtail production levels below actual demand because of worker vacancies.
Believe the Fed
What does all this mean? In our view its simple: Believe the Fed when it says two more rate hikes are coming for 2023 and that rates will be higher for longer.
What Should Investors Do?
There are few themes that investors may want to consider when looking forward:
1) Avoid leverage: Companies with large debt loads will face earnings headwinds from higher interest rate burdens. This impact will be immediate for those with revolving debt, but with a “higher for longer view” even companies with fixed rates maturing over the next 3-years will face earnings headwinds once maturities arrive and they are forced to refinance at higher rates.
2) Avoid companies needing to raise capital. In our estimation not only will debt costs be higher, but the equity cost of capital will rise as well. Those companies needing to raise capital will likely face investors demanding much higher returns than those required during the past decade of zero-interest rates.
3) Avoid companies with negative earnings and negative free cash flow. We think the paradigm of zero interest rates fueled a DCF driven surge in speculative companies where near- and medium-term negative cash flows were ignored due to fantasy like growth projections that pushed out all the value to the terminal value assumption, i.e. post 10-years. Rising debt and equity costs will most likely increase the WACC (weighted average cost of capital) divisor in the DCF for these companies and substantially reduce the derived present value price targets.
4) Focus on companies with low leverage and strong near-term free cash flow. A strong balance sheet and ample cash flow allow management teams to ‘stay on the offense’ and focus on valued added investment and potential compelling M&A opportunities – with the best opportunities from forced sellers.
5) Focus on barriers to entry, pricing power, brand strength and durable business models. We view 2023 as the return of a stock-picker’s market. Those companies with high demand assets, high barriers to entry (capital in place, patent protection, geographic positioning, etc.) and brands the inspire loyalty can maintain strong demand and pricing power to overcome interest rate and inflationary headwinds.
The Return of a Stock Picker’s Market
The end of zero-interest rates and quantitative easing has in our judgement marked the end of the risk-on, growth at any price investing environment. As the impacts of higher interest rates work their way through the capital markets, we suggest investors focus on the value factors of 1) capital strength, 2) the ability to grow and 3) a compelling discount.
It has always been our view that value is not the antonym of growth. In our judgement, to avoid value-traps, a company must possess what we call “the ability to grow.” A strong balance sheet, good free cash flow, and realistic growth ambitions are critical factors that can enable management teams to execute on value creating governance and capital allocation decisions regardless of Fed policies or broader stock market levels. What we see as the critical differentiation of the value vs. growth style is the ability to purchase a stock at a compelling discount to fair value, and not overpaying for themes that cannot live up to an economic reality.
Rewey Asset Management is a registered investment advisor in the State of New Jersey
*Notes:
January US CPI Urban Consumers MoM SA from Bureau of Labor Statistics, sourced via Bloomberg
January Adjusted Retail & Food Services Sales from U.S. Census Bureau, sourced via Bloomberg
January Capacity Utilization as a % of Total Capacity from U.S. Federal Reserve via Bloomberg
January US PPI Final Demand MoM SA from Bureau of Labor Statistics via Bloomberg
9/27/2022 RAM Blog Not Like Any Recession I’ve Seen (reweyassetmanagement.com)
December 2022 and September 2009 U.S. Job Openings by Industry Total SA sourced from the Bureau of Labor Statistics via Bloomberg.
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