Stocks drifted lower yesterday after a surprisingly hot inflation report for June. This once again raised issues regarding the possible timing of the Fed’s bond purchase tapering process. Strong earnings reports from Goldman Sachs and JPMorgan Chase# were met with yawns by the market as earnings season got underway. Only a strong quarter from Pepsico#, which not only beat forecasts but raised guidance, got investor attention. While we are just one day into earnings season, the message is clear. Good or even great second quarter earnings are largely priced into equity prices now. To push valuations higher, companies need to push investors to lift forward guidance. Given the market’s enthusiasm and recognition of growth to date, that will be tough for most companies to accomplish. With that said, there were no disappointments of note yesterday as earnings season got underway.
On Monday, I discussed transitions and the difficulties investors face trying to adjust to a new set of facts. Yesterday’s CPI report that shows inflation now pushing 5% brings into question the Fed’s repeated call that the recent inflationary surge is transient. You don’t have to be an English scholar to recognize that the roots of the words transition and transient are the same. Both suggest change. The Fed’s use of the word transient suggests that the current surge is tied to factors that will fade relatively quickly in the months ahead. Indeed, some, like lumber prices, have already reversed course. Some, like oil and gasoline prices, normally peak seasonally about this time. Oil producers have spare capacity. The issue is whether they will use it to meet demand or keep supplies tight to prop up prices. OPEC and non-OPEC allies like Russia can’t make up their collective minds. Best guess is that prices will stay elevated in the Summer but move lower in the Fall as they do seasonally over 90% of the time.
Rents are now rising again and shelter is over a third of CPI. Wages are also rising at a rate well above the Fed’s 2% inflation target. Wage and rent increases hardly qualify as transient. Fed Chair Jerome Powell will talk to Congress this week and his words will be microscopically dissected by investors. Even those who accept the transient notion fear the Fed could begin tapering sooner than previously expected given the spike in inflation.
The bond market continues to yawn, however. This may be largely due to technical factors. It also relates to the vast amount of cash on the sidelines looking for a safe place to park money. I have often questioned who will fill the gap when the Fed leaves the market. Looking at savings levels today, that doesn’t seem to be an immediate problem. Yet over time, long bond rates won’t stay low forever if inflationary pressures prove persistent and/or long lasting.
The other big news overnight is that Democrats on the Senate Budget Committee have agreed to a $3.5 trillion spending plan on top of the $1 trillion infrastructure plan that was previously agreed to by a bipartisan coalition in Congress. As always, the devil is in the details. Few were available this morning. The $3.5 trillion package is to be fully paid for with higher taxes. Since it is less than the original $6 trillion pie-in-the-sky proposals of progressive Democrats, all the tax suggestions offered to date won’t be needed. It is already virtually certain, for instance, that the ceiling for corporate taxes will be 25% or lower, not 28% as Biden proposed. It is also doubtful capital gains taxes will get anywhere near 39.6% for anyone. If the bill passes, there will be tax increases and they will be concentrated on the wealthy and business. I should note that most of the Democratic members of the Committee come from the liberal/progressive side of the Democratic Party. Only Mark Warner would be classified as a moderate. Bernie Sanders is the Chair. Thus, an agreement among Democrats on the Committee can hardly be construed as the final say. This package still has a long way to go before becoming law. It can only pass through reconciliation and that will require 100% Democratic support. It is probably a reasonable conclusion that, in order to satisfy Democratic moderates, many changes will be needed, and the size of any package passed will be smaller than $3.5 trillion. This, once again, plays into the transition theme. Government spending is likely to become a bigger piece of the GDP pie.
So far, our discussion of transition has focused on the overall market. But transition affects parts of the market differently. Declining growth rates will hurt cyclical companies more than those less economically sensitive. Should inflation push higher over time, the impact will favor lenders over borrowers. Should interest rates rise, P/E multiples will compress and be especially harmful to stocks elevated by hype and promise rather than earnings and cash flow.
If, indeed, we move to a world of slower growth, higher (but not high) inflation, and long- term interest rates that stay within the range of the past decade, where do we go to find winners and losers? Let me offer a few thoughts.
1. Stocks are risk assets, at least compared to bonds and cash equivalents. For stocks to go up over time, the underlying company must be able to grow sales and earnings persistently. Growth is easy when GDP grows by 10%. It gets challenging when that rate is cut in half or more. Great companies consistently gain market share and are nimble enough to protect profit margins.
2. Many asset classes have benefitted in recent years from the simple fact that money and most investment-grade bonds do not provide enough return to cover inflation. That has largely been due to the extreme accommodation of central banks. They have kept rates low and money supply high. Thus, not only are rates ultra-low today, there is an enormous amount of money sloshing around trying to find a home. That has not only elevated the value of high-risk assets, but it has also elevated both savings and bank deposits. That may not be a permanent situation should central banks take their foot off the monetary accelerator. Should bonds and cash equivalents once again provide a safe opportunity to generate a real return, the attraction of asset classes that generate no income, from Bitcoin to most SPACs, will be less. Bitcoin enthusiasts want to believe that Bitcoin, over time, will be a safe store of value. But if money can generate a real return and Bitcoin only bears a cost, similar to holding gold, it will lose relative attraction. Does that mean Bitcoin will decline in value once interest rates normalize? Not necessarily, depending on other factors. Lenders receive interest and Bitcoin holders do not.
3. A rising tide lifts all boats. When GDP is growing 10%, everyone can enjoy the ride. When real growth is a more normal 2-3%, the wheat gets separated from the chaff. Good companies win and gain market share. Look at the streaming world today. Every entertainment complex is now offering a streaming package. Some charge monthly rates. Some depend on ads. Today, it is reported that the average household has four streaming services. That doesn’t mean it pays for four. Amazon Prime is free to its Prime customers. If you get HBO from your cable provider, HBO Max is free for now. If you buy an Apple device, depending on the promotion, Apple+ is free. Ditto for Comcast and Peacock. This is all about jockeying for space and mindsets. History tells us that over time there will be less than a handful of dominant streaming services, together with a few specialized vertical market players. Some of the rest will be bought and consolidated into the bigger ones. Many will simply shut down. Perhaps a better case is retail. The pandemic saw the end of JC Penney, Brooks Brothers, J Crew, Forever 21, Lucky and others. Many more will die as economic growth slows. Some that seem to be recovering, like GAP and Macy’s, still face a tough road ahead.
4. Technological changes keep accelerating. The pandemic accelerated changes. Today, drug discovery is less about chemistry and more about biology and DNA. Physical cash is giving way to digital cash. When was the last time you stepped foot in a bank branch? What is the future for movie theatres and department stores? Is the gasoline engine the next dinosaur? If so, are all the new cars of tomorrow going to be made by Tesla and its clones, or is there a place for General Motors and the traditional car makers? Will waiters be replaced by tablets, phone apps, and kiosks? These are all accelerating trends. It will take years for electric cars to dominate new sales and decades for gasoline cars to disappear. Heck, I have one partner who still uses an electronic calculator and another addicted to the Blackberry. Investors won’t wait for the last person to give in. They see trends early. Just as it was famously said that markets have forecast 10 of the last 3 recessions, futurist’s projections don’t always happen, and most don’t happen nearly as quickly as expected. Between 1900 and 1915, there were over 3000 companies in the car business as the car was completely replacing the horse and buggy. Well over 2900 failed, most almost immediately. Many of the new electronic automotive and truck companies that have raised money over the past year won’t ever see their revenue dollars before failing.
Bottom line: Decelerating separates winners from losers. You want to be invested in companies that persistently gain market share, that can maintain growth rates in a decelerating economy, and that reward investors via dividends and stock buybacks. Should rates rise, lenders benefit more than borrowers. Balance sheet quality matters when there is a real cost to money. Finally, don’t get ahead of yourself. Don’t act on future tax consequences that may not happen. Stay in touch with your tax advisors, which include your investment managers, to keep up to date. Finally, match your risk profile to the environment. It has been a great past few years. Now is probably not the time to reach too far. The two watch words of good investors are patience and discipline.
Today, MMA fighter Conor McGregor is 33. The character actor Jane Lynch is 61.
James M. Meyer, CFA 610-260-2220