An Economy Running On One Engine
In today’s unusual environment, headline economic data mask varying underlying conditions. The most recent GDP report showed headline economic growth, with the goods segment contracting as the services segment expanded as the one engine keeping the economy aloft. Company management commentary on earnings calls similarly varied across industry groups. Consumer-facing service companies reported strong demand, while other sectors experienced a mixed environment. The past few years have seen rapid dips and spikes in demand occurring asynchronously across sectors.
A recent The Wall Street Journal headline captures the evolving cycle: “For Chip Makers, the Flip from Shortage to Glut Intensifies”. The article describes declining chip maker production as customers draw down inventories rather than place new orders. Yet the longer-term outlook is not so dour. Companies are trying to balance “near-term trouble against their expectations for longer-term growth.” Companies taking a conservative approach has unfolded across countless industries.
Strong consumer demand continues the last part of the pandemic cycle. A stable job market and excess savings will likely extend the consumer spending cycle despite inflation challenges. Even so, rapid interest rate increases clearly suppress some economic activity, notably housing.
Implied predictions for Federal Reserve interest rate hikes point to a peak sometime from March to June. Whether the economy experiences a recession or a soft landing depends on the unpredictable timeline of rate hikes compared with the remaining “excess demand” in the consumer portion of the economy. We estimate one to three quarters of solid consumer demand, as a result of spending on services remaining below pre-COVID trends, as well as solid job creation (new spenders), and excess savings. The Atlanta Fed’s GDP Now model (+4.00) and the New York Fed’s Weekly Economic Index (+2.10) both point to modest fourth-quarter growth. The pandemic cycle is nearing an end and conditions will return to their long-term trend of slow growth.
Inflation—It’s Not Over Until It’s Over
In the near term, inflation as measured by the Consumer Price Index (CPI) remains critically important for market direction. Any improvements in CPI will lead investors to expect less aggressive rate hikes, which should in turn boost valuation metrics such as Price/Earnings (P/E). As earnings season draws to a close, and with the next Fed meeting not until early December, CPI will capture the lion’s share of attention.
CPI is a flawed metric as it provides lagged indications which some confuse with current conditions. For example, rent costs have become hotly debated, as there is meaningful divergence between rent costs as measured by CPI and “real-time” indicators of rent costs. “Real-time” metrics reflect only the most recent data points. Therefore, the real-time metrics reflect the decline or moderation in rents much faster than will appear in CPI. Yet the FED and most investors seem more focused on CPI. In other words, there is debate as to what “improving” inflation looks like, and the focus on CPI instead of real-time indicators has pushed the Fed toward further rate hikes, rather than making real-time calls that things are improving.
Beyond rents, there are other signals that current prices are improving (i.e., declining or at least stabilizing). Used car prices per the Manheim index, which hit a peak of +54.2% on a year-over-year basis in April 2021, are now down -10.6%. These signs of improvement, however, will not benefit investors until they flow through CPI and, more importantly, affect the Fed’s interest rate plans. Inflation will only be over and done for investors when the Fed can clearly change course.
Earnings—An OK, but Mixed Picture
Third-quarter earnings were fine but contained a lot of mixed messages. Thus far, 461 companies have reported, with small upside surprises in sales +2.60% and earnings +2.94%. The consensus earnings forecast for 2023 are $236.49, although we expect that number to come down when companies provide formal guidance early in the new year. The dollar had been strong, trading at multi-year highs, which hurts the earnings power of large companies that sell overseas. The dollar’s strength has become more neutral of late, and removing the headwind of a strong U.S. Dollar could be beneficial.
On the other hand, rising interest expenses are likely to be a drag on earnings. Grant’s Interest Rate Observer estimates that a 400 basis point increase in the Secured Overnight Financing Rate (SOFR) could increase interest expenses by 20% of EBITDA for a 5x levered company. (SOFR replaced LIBOR as a standard reference base rate on loans. EBITDA is Earnings Before Interest Taxes Depreciation and Amortization). As the sting of higher rates begins to hit earnings, a focus on higher-quality companies with strong balance sheets should prove fruitful.
Recent election results point to a mostly divided government, with no strong mandate for either party. Typically, this is good for investors, as less legislative change allows investors to “look ahead.”
Outlook
Steady consumers and decent earnings have extended the economy’s runway by a few months, as we wait on an improvement in inflation. Should inflation worsen (we don’t expect it will), or should the economy falter (we think not yet), markets could experience another downdraft. For now, we expect choppy conditions, with improvement only when inflation merits an improved outlook by the Fed. The consensus earnings outlook is a modest 6.54%, which puts stocks at a 16.73 P/E. The short-term valuation outlook is highly unpredictable and will move based on CPI reports. We prefer to focus on a longer time horizon—at least three years —where we expect earnings gains of about 5%, a level below long-term trends. Fed Chair Powell has made clear that the Fed will remain a foe to markets until inflation has improved. Improvement in inflation will ease pressure on the Fed, bringing additional clarity to the rate outlook, which will in turn boost valuations. Over our three-year horizon, we expect modest gains in earnings and some improvement in valuation as inflation eases. For investors who understand the Fed isn’t their friend in the short term, equities offer the potential for high single-digit gains.
This communication contains the personal opinions, as of the date set forth herein, about the securities, investments and/or economic subjects discussed by Mr. Teeter. No part of Mr. Teeter’s compensation was, is or will be related to any specific views contained in these materials. This communication is intended for information purposes only and does not recommend or solicit the purchase or sale of specific securities or investment services. Readers should not infer or assume that any securities, sectors or markets described were or will be profitable or are appropriate to meet the objectives, situation or needs of a particular individual or family, as the implementation of any financial strategy should only be made after consultation with your attorney, tax advisor and investment advisor. All material presented is compiled from sources believed to be reliable, but accuracy or completeness cannot be guaranteed. © Silvercrest Asset Management Group LLC
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