The Times They Are A-Changin’
One of our favorite Wall Street sayings is that “trends continue until they change.” In 2022, two long-term trends changed. Inflation, which had consistently drifted lower over the past 40 years, suddenly rose – partially for structural reasons and partially for temporary ones. Ditto for interest rates. The yield on the 10-year Treasury peaked at about 16% in 1981 and then fell over the next four decades to below 1% in 2021. The positive implications of this multi-decade trend for risk assets are difficult to overstate. In 2022, this trend dramatically changed, as rates shot up to roughly 4% and could go higher as the Fed continues its efforts to contain inflation by raising the cost of borrowing.
The upshot of these sea-changes in inflation and interest rates in 2022 was a bear market across pretty much every asset class from bonds to stocks to real estate. The stock market (as measured by the S&P 500) fell by roughly 25% peak to trough during the year but has partially recovered recently. As of 12/31, it was down over 18%. The tech-heavy Nasdaq was hit much harder, down 33% in 2022. Treasuries, widely described as “risk-free” because of the assurance of repayment by the federal government, had an historically bad year, with investors in 10-year Treasuries seeing a loss of nearly 17% in 2022. Higher mortgage rates have pummeled house prices. Most other forms of real estate also came under pressure. With asset prices broadly down, the good news is that expected future returns are higher. Asset prices could, of course, go lower before entering a new secular bull market, but it appears that we are now in a bottoming process that will ultimately allow asset prices to rise again. How soon, from what level, and how fast they recover is a matter of debate. The answers depend on the interplay between secular and cyclical forces and the Fed’s determination to squeeze inflation back down to around 2% from its current level of over 7%.
To understand how inflation has made such a dramatic and unwelcome turnaround in such a short period of time, it is helpful to review a bit of economic history. For the past several decades, inflation has been held in check by the twin forces of technology and globalization. Technology enabled businesses to become much more efficient and gave consumers and businesses unprecedented price discovery powers. Globalization opened vast quantities of cheap foreign labor, which enabled businesses to relocate manufacturing operations to countries offering less expensive workers. This kept the lid on U.S. domestic wages. As inflation subsided, profits rose, interest rates trended lower, and asset values expanded.
While technology is still a deflationary force, globalization is not. In fact, we have swung from a period of labor surplus to labor shortage as China’s labor force is now aging. In addition, the persistent supply chain shocks of the past two years have highlighted the risks of being overly reliant on foreign operations. And escalating political tensions between the U.S. and China have raised the specter of future disruptions. This constellation of factors is inducing U.S. manufacturers to bring operations back home — leading to a trend of re-shoring and near-shoring. These shifts in the labor market supply demand balance portend higher trend-line inflation than the sub-two percent inflation we experienced for a couple of decades.
Adding to inflationary pressure are two cyclical or temporary pressures. The first is Covid, which led to the aforementioned supply chain issues, creating both shortages and price increases. The second is the war in Ukraine, which has led to disruptions in commodities like oil and grains, leading to higher prices for both. The combination of all these factors pushed headline inflation from under 2% to over 9%. While inflation has peaked, and is heading lower, it is still well above the Fed’s target.
Since the Fed is determined to push inflation back near 2%, it will likely continue monetary tightening and keep interest rates elevated through much of 2023. This may cause a recession, which could pummel corporate profits, which in many cases are already suffering from inflationary cost pressures. All this adds risk to the stock market, but it may also set up the market for a strong rally once the Fed takes its foot off the brakes.
For investors, the key is to position portfolios to withstand the near-term risks stemming from possible recession and inflationary cost pressures on the one hand, and on the other, to benefit from the eventual economic upturn that will inevitably follow any slowdown. We believe that equities best suited for this environment should have the following characteristics:
- Market Dominance – Companies with leading or dominant market positions generally have better pricing power and are thus able to pass on inflationary cost increases. They are often the most efficient companies in their respective markets and are therefore better able to control cost in the first place. Such companies also tend to gain market share over time and so are able to benefit during times of stress.
- Secular Tailwinds – Companies in industries with secular tailwinds should have an easier time growing than those facing headwinds.
- Strong Balance Sheets and Cash Flows – Companies with strong balance sheets and substantial cash flows are better able to navigate difficult times and are thus able to gain market share during rough periods. They can also sustain themselves through a high-interest rate regime.
- Growing Dividends – Since the Great Financial Crisis, earnings growth has been the predominant driver of stock market performance, but historically dividends have accounted for a sizable portion of equity returns. We are now in a period when dividends are regaining importance. Companies that can raise dividends over time will be rewarded and should prove to be superior investments.
- Attractive Valuations – In a world of 1-3% 10-year Treasury yields, multiple expansion and higher valuations were justified, as long as rates stayed low. With rates so low for so long, investors were encouraged to pile into profitless high-growth, even speculative assets. As the cost of capital for companies increases, basic corporate finance theory dictates lower valuations and a focus on near-term cash flow. In many ways, this is a return to normal.
To the extent we can identify companies that exhibit these characteristics and whose stocks are temporarily depressed because of a short-term, fixable problem, we should be able to build portfolios that are positioned to better withstand periods of uncertainty and flourish during periods of economic expansion. We intend to focus on the medium- and long-term investment horizon because when you own a great company at a good price, time is your friend.
Please reach out if you have any questions.
© Osterweis Capital Management
Read more commentaries by Osterweis Capital Management
