How did we get here?
In March 2020, the global economy was hit by a shock that left millions of people out of work. After a few weeks of commotion, central banks swiftly responded, reducing rates and increasing quantitative easing. In addition, governments implemented generous fiscal support, aiming to mitigate the adverse effects on individuals and businesses.
As a result of this policy easing, aggregate demand experienced a notable increase. Despite the persistent constraints on aggregate supply caused by pandemic disruptions, at this point inflation remained relatively subdued due to the presence of labour market slack.
Eventually, however, aggregate demand did catch up and surpass supply, causing a marked increase in inflation. This took both the US Federal Reserve (“Fed”) and many strategists by surprise, with Fed Chair Jerome Powell himself erroneously dismissing inflation as “transitory”.
However, as readers of past Market Synopses would know, persistent inflation was almost expected when assessing the kinked Phillips curve framework. A phenomenon that last appeared in the second half of the 1960s, when inflation suddenly surged. In both cases, the kink in the Phillips curve was a result of the jobs-workers gap (the difference between labour demand and labour supply) reaching all-time highs.
Just under a year later, the Fed wisely abandoned its “transitory” narrative and began raising rates. Again, the government duly following suit, tightening fiscal policy from a peak of 14.1% of US GDP in 2020 Q2 to -4.8% in 2022 Q2 according to the Brookings Institution.
To the relief of central banks and many investors the combination of tighter monetary and fiscal policies helped curb the rising demand. At the same time, US labour participation rebounded, and global trade began to once again function smoothly, increasing the supply of goods and services and inflation began to fall. Several core measures of inflation, which aim to depict the underlying trend in inflation, illustrate how inflation reached its peak in mid-2022 and has gradually decreased since then – see Figure 1.
Figure 1 – Core inflation is receding
We expect that US inflation will continue to decline, as multiple leading indicators continue to point to lower inflation. For example, the NFIB survey of business owners, which reliably leads core PCE inflation, illustrates that the number of small business owners planning on raising prices has declined to levels last seen 2019 – see Figure 2.
Typically, as inflation falls, unemployment rises as the supply of labour continues to grow faster than demand. However, as we have observed over the past few months as inflation receded unemployment has not risen. Again, the kinked Phillips curve framework explains why: As the economy is at full employment, falling labour demand results in declining job openings rather than rising unemployment. Encouraging the hopes of market participants that the US economy might really experience a soft landing.
Figure 2 – Inflation is set to fall further
However, there is a catch
However, the story may not be done just yet. The kinked Phillips curve goes on to predict a third event. As inflation falls towards the Fed’s target, the likelihood of a recession increases rather than decreases as many would expect. That is because as aggregate demand declines towards the kink in the curve, there is real chance that it continues to decline past the kink. When this happens, output will begin to drop rapidly, and unemployment will rise. Just as the market assumes a soft landing has been achieved, a hard landing will begin. It is impossible to accurately forecast when the hard landing will begin, and for now there are still not enough headwinds to provoke a recession. The number of job openings remains robust, and the USD 1.2 trillion in excess pandemic savings should last another 15 months before depletion. As a result, we believe that a US recession will likely start in 2024, and probably only in the second half of the year.
Near term support for equity markets
We have written before how US equity indices have been driven higher this year as mega cap tech shares rise on an AI investment frenzy. Having said that, the S&P 500 equal-weight index has still managed to eke out a 16% rise from the lows in October 2022. We believe the S&P 500 has also been buoyed by investor hopes of a soft
Until the recession does occur, we think that equities should continue to see upside, driven by rising company earnings. Since February of this year the US 12-month forward earnings estimates have risen 2.5%. This is after forward earnings estimates have declined for eight straight months – see Figure 3. In the months that earnings estimates were being cut, forward revenue estimates barely declined. Indicating that margin compression has been the driver of lower earnings. However, as inflation slows, we believe margins should remain stable, at least until the recession occurs. As sales continue to grow, and margins remain constant, earnings will grow too, providing near-term support to equities.
Figure 3 – US earnings growth has been well below revenue growth
Fixed income markets in a tug of war
Until the recession arrives, we expect bond yields to continue to be stuck in a tug of war between falling inflation (leading to lower rates and thus lower required bond yields) on the one hand, and a still resilient economy on the other hand (reducing the demand for safe investments, pushing yields upwards). We feel that a neutral-to-short duration position in the short term, followed by an overweight long duration position later this year would be wise as the economy begins to cool.
Why we are underweight US equities
The price-to-earnings (“P/E”) multiple that an investor pays for a share is an important investment consideration. It helps one better understand if a share is over- or undervalued in comparison to its competitors and industry. Shares with higher P/E ratios tend to carry higher investor expectations of continued strong earnings growth. As a result, if a high P/E share falls short of achieving their forecasted earnings, the price of the share tends to fall precipitously. A function of the market adjusting the company’s P/E lower, to a multiple more in line with the slower earnings growth expectations of that company.
Therefore, an investor that remains cognisant of P/E multiples, amongst many other factors, when investing can work to construct a portfolio that aims to avoid the potentially large drawdowns experienced when investing in high P/E shares. This also helps the investor remain protected from getting caught up in speculative investments such as those present in the broader US equity markets.
The Fed’s Principal Economist, Michael Smolyansky, recently released a paper titled “End of an era: The coming long-run slowdown in corporate profit growth and stock returns”.
The paper points out that from 1989 to 2019, the S&P 500 index grew at a real rate of 5.5% per year, while the US real GDP grew at only 2.5%. Prompting one to ask, what lead to this discrepancy? The paper finds that there are two contributors to the outperformance of the share market over this period. The first is the substantial decline in both interest rates and corporate tax rates over the last 30 years. Which significantly boosted corporate profit growth, with as much as 40% of the growth in real corporate profits being attributed to the above factors.
From 1989 to 2019, real corporate profits grew at 3.8% per year, almost double the pace observed from 1962 to 1989. However, when comparing the growth of earnings before interest and tax (“EBIT”), growth was actually lower from 1989 to 2019 at 2.2% per year compared to 1962 to 1989 at 2.4% per year. Figure 4 below depicts how over the period interest expenses and corporate taxes halved from 54% of EBIT in 1989 to 27% in 2019. This allowed companies to reduce the share of earnings paid out to debtholders and tax authorities, while the share of earnings available to shareholders continued to grow.
Figure 4 – Interest and tax expenses as a share of EBIT
Looking forward, it is unlikely that US interest rates will be able to fall further than the low levels achieved in 2019. Of course, since then higher inflation has led to substantially higher interest rates, removing the tailwind that once helped corporate profits grow. From a corporate tax perspective, it does not look much more promising. The effective corporate tax rate for the S&P 500 non-financial firms declined from 34% in 1989 to 15% in 2019. While it is not impossible that corporate tax rates get cut even further, another deficit-financed tax cut appears unlikely given the U.S. debt-to-GDP ratio is near all-time highs.
Therefore, if we assume interest rates and US effective tax rates remain close to their 2019 lows, profits can only grow at the same rate as EBIT. From 1962 to 2019 EBIT grew at just below the US GDP growth rate. Therefore, real corporate profits can most likely be expected to grow in line with the real US GDP growth rate, which is no more than 2% per year.
The second source of S&P 500 outperformance is as a result of the declining risk-free rate over the period. P/E multiples are primarily a function of discount rates and earnings growth expectations. Over the last 30 years, the declining discount rate led to the expansion of P/E multiples of companies listed on the S&P 500, as depicted in Figure 5.
Figure 5 – US P/Es have risen well above other regions
Given that interest rates are unlikely to fall much further than those observed in 2019, any further expansion of P/E multiples would only be possible with an increasing growth rate in company earnings. Which as we have already pointed out is unlikely. Given that the US market’s P/E remains well above other regions – as seen in Figure 5 on the previous page. It appears that market participants have yet to price in the new lower expected growth rate in US earnings. When this does occur, it could result in a material contraction in P/E multiples and thus a broader decline in US market indices.
As we highlighted earlier, the investor that remains cognisant of P/E multiples, among many other factors, when investing can avoid most market manias and their resulting drawdowns. For example, the Integrity Global Equity Fund, which subscribes to a value investment philosophy, remains underweight North American equities relative the MSCI AC World Index, as seen in Figure 6 below. This should allow the fund to outperform in the case that US equity markets rerate on lower long term growth expectations.
Figure 6 – Integrity Global Equity Fund regional allocation
While US inflation continues to decline, market participants will be lulled into the belief that the likelihood of a soft landing is increasing. Supporting a continued rally in equity markets this year. However, as aggregate demand continues to decline, and eventually slips past the kink in the Phillips curve, output will begin to drop rapidly, and unemployment will rise. At this point the hard landing will begin. Furthermore, we remain underweight US equities as the region faces long-term headwinds as interest rates and corporate tax rates become ever more constrained in their ability to decline.