It’s been quite a year and a half. We moved from a quick, harsh recession and stock market decline to an even faster recovery. There seems to be fairly broad agreement that we’re currently seeing a lot of peak growth numbers in inflation, GDP, and earnings growth. But what comes next?
Consensus says that we’ll see a gentle Bunny slope down in these growth rates. The numbers will still grow, but at slower rates.
Inflation seems to be the biggest bone of contention, with calls ranging from hyperinflation to deflation. That’s because forward inflation is really hard to gauge. There are a lot of factors involved, including consumer inflation expectations, and the interplay among factors can be pretty complicated. A lot of models just look at the trends in things like commodities (lumber, oil, etc.) and assume they continue. That works most of the time, but it certainly won’t catch the peak. Does the CPI go from 5% to 4% (consensus)? Or to 7%? Or to 1%? What does it look like at the end of the year? Next year? Tough questions.
Similarly, the generic assessment of GDP is that it slows, slowly. GDP is expected to broadly go from 9% to 7% to 5% to 4% to 3% as the quarters go on. Honestly, that sounds pretty good, as it implies we’ll make up for lost growth and it’ll almost be like this Covid unpleasantness never happened. As for earnings growth, Bank of America says global earnings growth peaked in April at 39% growth year-over-year, which is actually fairly similar to what happened after the 2008 earnings wipeout when earnings growth peaked in 2009 and then steadily declined to close to 0% growth by 2012.
If there’s one thing I’d say, it’s that there’s a tremendous amount of uncertainty surrounding all of these estimates. Will we see more government stimulus, or will Congressional gridlock slow things down? How much will cost pressures hurt margins and buying patterns? How quickly and to what extent does the world reopen? These are more tough questions.
We are starting to see some troubling signs. Small business, in particular, is having a hard time with staffing, and they say it’s impacting their business. They also face input cost pressures. The combo is making a significant number of small businesses say they may fail. The latest buying intentions are seeing a cooldown, as prices soar. In some areas the recent surge of inflation is moving in the other direction, with lumber down 18% last week and down 40% from the record peak in May. I wonder if we’ll see more of this, as I think shortages create overbuying, as people want to secure supply. If end buyers slow, companies can wind up with a lot of unprofitable inventory.
What if the Bunny slope view of gently slowing growth rates doesn’t quite work out? Isn’t that what the Treasury market seems to be saying, as it sees current data, shrugs, and sends yields down? The Treasury market tends to be right more often than the stock market. Shouldn’t we pay some attention?
Instead of a Bunny slope down, could we be facing a Matterhorn slope? Honestly, it’s hard to imagine things go wrong too fast, as financial conditions seem so accommodating and risk appetite is so high. Could we see a 5 or 10 percent market decline in the coming months? Sure, but how big of a deal would that be? It certainly isn’t a Matterhorn-type slope.
How could a relatively modest 5 or 10 percent decline happen? Sentiment has been very high, and risk taking is also high. It wouldn’t take much of a bobble in economic data, government actions or investor psychology to knock some air out of the market. Tech and small caps have been the winners of late, but there are a fair number of other stocks that aren’t participating in the recent strength. It’s also worth noting that, according to Bank of America, at least over the last 75 years, peak CPI numbers lead to a notable decline in Treasury yields over the next three months. In turn, Treasury rates correlate mostly with economic growth. Earnings expectations are generally pretty high, and it’s easy for me to imagine disappointment there. So, it’s easy to see a modest market downturn.
More interesting and significant for me is what happens once we start lapping the stimulus numbers from the last year. Expectations are that we will replace that stimulus with economic growth, and perhaps a bit more stimulus, but what if that doesn’t happen? This probably isn’t much of a problem in the short term, but eventually people will start focusing on the fourth quarter and next year, where disappointments could start getting larger. Given high expectations, that could potentially get ugly.
So, what do we do with all this? I do think the market has done a good job with anticipating changes of late. For instance, the market got ahead of the idea of peak growth numbers and started buying more defensive names. Similarly, I want to get ahead of the current possibilities. My basic issue is that reflation and reopening plays have already been priced in pretty well. What comes next? Who really knows for sure? Seems like there are a wide variety of possible outcomes.
My view is to consider what are likely future investment choices that offer a good risk/reward setup, where you can get rewarded if you’re right, but not hurt too badly if something unexpected happens. That way you can invest and adjust as new data comes up. In general, I’d look for high quality names that don’t change too quickly. You may not make a fortune, but, more important, you also won’t get hurt too badly. I think there are a lot of names that can fit that bill, starting from drug companies to industrials to staples to big tech. Try to buy them when they’re out of favor or on the ropes and hold them unless conditions change. Again, that’s not very exciting, but it keeps us in the game while we wait to see what the next really attractive pitch is for us to take a swing at.
The last area I’d mention that fits the bill is precious metals miners. Like everything else, the pricing isn’t as good as it was a year ago, but historically and over time they benefit from monetary expansion, and that seems like a fair bet. In addition, they have the best cash flow prospects I think they’ve ever had in my career. It seems to me like a rare deal where downside, particularly over time, seems limited, while potential upside seems great.
In general, I think we’re dealing with a wide variety of realistic, possible views right now. With a great deal of uncertainty, I think it makes sense to wait and see what comes. Some of the latest data certainly points to peaks, which historically is worrisome. The fact that so many people seem to expect a Bunny slope ahead also has me worried that seeing something worse may cause more significant problems in investor psychology and the markets.