Reasons for Optimism: Equity Investment Outlook Fourth Quarter
The third quarter of 2021 was characterized by a highly volatile equity market that closed largely unchanged for the quarter as investors struggled to reconcile forecasts for strong but decelerating GDP growth, rising inflation related to supply chain bottlenecks, and a looming Fed taper. We expect the market to continue to grapple with these issues in the near term. In particular, the market appears to be struggling with the question of whether the economy is experiencing a growth pause caused by a combination of expiring stimulus, the Delta variant, and supply chain issues or a more structural slowdown reflecting a low demand environment with more than just “transitory” inflation.
These questions lead to longer-term market uncertainties. What kind of economy meets us on this new post-pandemic journey — one marked by 1970s-style stagflation? We don’t think so, given the globalized and technology-enabled economy of today. Another possibility is a return to the low growth, low inflation world that we experienced post the Great Financial Crisis up to the beginning of the pandemic, from 2009 to early 2020. A third outcome is a 1990s-style economy characterized by higher inflation, but also higher growth. We see the latter as a distinct possibility, with potential for an extended cycle of capital investment providing the impetus for broadening growth and job creation.
Our bias toward this outlook is based on a few presumptions. The pandemic has laid bare the need for an extended investment cycle. For example, we have witnessed the inherent structural risks associated with global just-in-time supply chains, which are a root cause of the shortages and bottlenecks we are currently facing. We suspect the remedy to this is the reshoring of manufacturing capabilities and supply chains to geographies that are closer to the markets where customers live. The proliferation of omnichannel retail only makes this trend more acute.
We are also seeing signs of energy stress, with demand for energy outstripping supply, resulting in multi-year high prices for crude oil and natural gas. Due to the combination of shareholder demands that traditional energy companies put less money into the ground and return more money to shareholders, along with societal pressures for de-carbonization, we see the potential for the energy shortage to persist. The need to fill the gap between supply and demand will drive investments in alternative sources like wind, hydrogen, and solar.
Real wages are also rising at a rate we haven’t seen in decades. The higher wages are likely due to a constellation of factors that have led to near-term labor shortages: a wave of Covid-induced early retirements (2 million above normal), massive labor dislocations created by the pandemic lockdowns, more workers choosing to stay home due to safety concerns and increased government stimulus, and slowing population growth caused by the tragic decline in life expectancy, lower birth rates, and stagnant immigration rates.
Whether these trends become the impetus for long-term structural inflation is an open and critical question. Within these trends, we see both temporary and structural forces at play. For example, on the temporary side, many of the supply chain issues should be resolved in the next year or so, and the wage step-up will likely stick, but super-normal wage growth should not persist. On the structural side, as noted above, we think the bottlenecks have laid bare major shortcomings in global supply chains that could lead to permanent changes and a large investment cycle.
In addition, everyone in Washington, D.C. seems to agree that infrastructure spending is necessary, which should create a persistent bid for raw materials such as steel, aggregates, and copper. In combination with re-shoring of global supply chains to carry more inventory, we will likely see increases in demand for logistics and warehousing. The need for jobs to support all of this investment would make an already tight labor market even tighter.
Underneath it all – China is no longer providing an endless supply of cheap labor. Its aging population, rising costs, extended supply chains, and increasing political uncertainty all point to incremental demand for labor in the U.S.
However, there are also strong deflationary forces to consider. Technology and automation have proven to be among the most powerful forces of the last 30 years. To us, it’s amusing to ponder how in the span of two years the labor conversation has pivoted from robots taking everyone’s job to structural labor shortages. Recent policies in China point to less investment in hard assets, especially in housing, which would lessen demand from the largest buyer of raw materials over the past thirty years. Another factor to consider is demographics – the developed world and China are aging. The result is lower aggregate demand and population contraction. Finally, debt is generally viewed as deflationary. Today the ratio of debt to GDP is well above any level in modern times.
It would seem to us that the sum of it all is both above-trend growth and higher but still manageable inflation. Inflation related to raw materials should be transitory – there is plenty of capital and technology for supply to catch up to demand – offset by more persistent upward wage pressure. We don’t necessarily see this a bad thing. Real wages are still below historical levels, and the recent increase in incomes should be supportive of consumption, which accounts for nearly 70% of U.S. GDP.
If this scenario plays out, we expect interest rates to move higher from current levels. The Fed welcomes the recent inflation surge, but persistent inflation above 2% would likely lead to a gradual rate increase, which bears monitoring.
In our portfolios this means we will continue to move toward a balance between cyclical and secular growth. We do not see a let up in secular trends like digitization, cloud computing, and alternative energy. But in this note we also lay out the case for an extended investment cycle that will aid industrial and transportation companies (for example). For both the cyclical and secular opportunities, we remain committed to investing in industry leaders who possess competitive advantages that will drive above-industry growth. Among secular growers these are companies that often have proprietary technologies, network effects, and significant data advantages. For more cyclical companies we favor those with pricing power and scale advantages that can offset rising costs, and these companies tend to be significant share takers within their sectors.
Please let us know if you have any questions.
John Osterweis, Larry Cordisco
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