Is It Time to Turn Bullish?
How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.
Robert G. Allen
What this research paper is about
As long-term readers of my work will be aware, I have worried about the economic outlook for a while. A mixture of runaway inflation and poor growth prospects had, and still have, stagflation written all over it, and that caused me to turn negative on equities early last year. In the last research paper on the topic, dated August 2022, I predicted that a 2023/24 recession was almost a certainty in Europe whilst ‘only’ likely in the US. See here for details.
My negative stance on equities has had a tilt, though. The extended underperformance of European equities relative to US equities opened up a valuation gap that, at the peak, was well over 30%, causing me to favour European equities over US equities. Although European equities have outperformed US equities more recently, they are still 20-25% cheaper, depending on the methodology applied.
In this research paper, I will challenge my own views. I will look at various recent data, some of which point towards continued economic growth. This paper will focus on the US outlook for the simple reason that it there that the economic data paints the most upbeat picture. That said, if the US were to escape a recession, the likelihood of Europe falling into one would also decline.
Why the economic growth outlook is brighter
There are two reasons why the economic growth outlook has become brighter. The first of those two has to do with manufacturing. In mid-April, the state of New York went public with manufacturing order statistics in the Empire State for the month of March, and the numbers were terrific (Exhibit 1). As you can see, the order book grew more in March than it has done for many years. Having said that, as you can also see, the order book has been extraordinarily volatile during the Covid pandemic with big swings in both directions. One should therefore interpret the March numbers with some caution.
It is also important to point out that Exhibit 1 covers manufacturing orders only, not manufacturing output, and that the report covers only the State of New York. Two comments:
1. Manufacturing output for the country as a whole was actually down in March – 1.1% year-on-year to be precise. A more positive trend in orders will take a few months to filter through to actual output.
2. The State of New York has historically proven quite a trustworthy leading indicator for the country as a whole (source: Bloomberg); i.e. a solid month of March for the State of New York could spell a brighter outlook for the whole country later this year.
The other reason the outlook is brighter has to do with inflation. In March, US producer prices fell -0.5%. Expectations were for a largely flat number. This is clearly good news, as PPI is a solid leading indicator of CPI. Core PPI is now down to 3.4% after peaking at nearly 10% early last year (Exhibit 2).
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Core inflation distinguishes itself from headline inflation by excluding non-core items like food and energy. A friendly soul asked me recently, how come food inflation is treated as non-core? Isn’t it very much a core item? I struggled to answer the question so had to do a little homework.
The answer is that it is the choice of the word “core” that causes the confusion. I don’t think anybody would disagree that food is an absolute necessity for human survival and thus a core item, as most of us define the word “core”. However, statisticians chose to label items like food and energy “non-core”, as food and energy prices can be very volatile and therefore sometimes paint a somewhat misleading picture of overall inflation. The two most important drivers of core inflation are wage inflation and shelter inflation.
The reason I mention this is that US shelter inflation, after a year or two of being virtually out-of-control, has finally turned negative again (Exhibit 3). From this point, it is therefore primarily wage inflation we should worry about, if we want core inflation to come down to acceptable levels again. Although not shown here, I can tell you that US wage inflation continues to be relatively high – about 6.4% as of the latest count in March (source: Atlanta Fed).
From an investment point-of-view, the news get even better. As you can see in Exhibit 4 below, the spread between CPI and PPI is rising and is now 2.2%, and that will have a positive impact on corporate profitability in the quarters to come. Corporate profit margins improve when CPI is rising faster than PPI, as companies can then raise their prices faster than the price they pay for raw materials.
In short, it is the combination of a strong order book, declining inflation and a rising spread between CPI and PPI that, on the margin, have affected my negative views on the economic outlook and on the outlook for US equities. I deliberately say “on the margin”, as the story is not as straightforward, as I have made it out to be. More on that below. I should also point out that one cannot necessarily assume that, just because the US outlook is brightening, so is Europe’s.
Diesel is the fuel that powers the global economy and demand for diesel is weakening. In the US, demand is on track to contract 2% this year. In Europe, diesel’s premium to crude futures is now the lowest it has been for more than a year, and, in China, commercial diesel stocks are rising rapidly – all signs of weakening economic activity (Exhibit 5).
Another factor that points towards recessionary conditions, at least in the US, is the sharply rising number of US states where jobless claims are rising by more than 30% (Exhibit 6). Historically, this has proven a very reliable indicator of a recession to come.
Jobless claims measure the number of workers filing to receive unemployment benefits due to not having a job and is an important leading indicator of the health of the economy. If jobless claims are rising sharply (as they are), it signals a weakening economy.
The bottom line
It is therefore fair to say that the picture is somewhat fuzzy. On the one hand, there are some pretty persuasive arguments in favour of continued economic expansion. On the other hand, it is not too difficult to come up with a string of arguments in favour of economic contraction. To a degree, it is therefore down to judgment, i.e. what can I learn from my many years of investment experience? In that respect, the needle is pointing towards economic slowdown but not a recession, i.e. a soft landing.
That said, apart from the UK, it is not a clearcut case, and the probability of recession later this year and/or next continues to be higher in Europe than in the US. Only 2-3 months ago, I would probably have argued for at least 75% in Europe, but recent numbers coming out of Germany – Europe’s economic locomotive – have made me reduce that estimate. My new estimates are as follows (Exhibit 7):
Implications for equity investors
Given the dire outlook in the UK, I expect UK equities to continue to underperform. Only two caveats:
1. If risk assets are suddenly going out of favour worldwide, UK equities will most likely outperform. As equities are cheap and dividend yields high in the UK, UK equities have turned into a risk-off asset class, i.e. they outperform on difficult days. Should we enter a full-blown bear market this year or next, I would expect UK equities to outperform.
2. If investors stick to the relatively small universe of UK companies that do not do much business in the UK, they could also outperform. Many of these companies are largely unaffected by the domestic turmoil. More often than not, they pay attractive dividends, and they look attractively priced om
As far as the EU is concerned, I find the discount on offer vis-à-vis US equities very attractive and would argue it is there because a European recession has already been discounted, whereas a US recession has not. Therefore, even if the EU falls into recession and the US does not, the valuation discount on offer should be big enough (20-25% at present) to protect investors in European equities.
The US equity market outlook is trickier. Over the past 18-24 months, the clients I advise have all been either short US equities or neutral on them. I think it is time to revisit that stance. For the most risk-averse, I would recommend a continuation of the neutral strategy, but I would advise against shorting.
For those with a modest amount of appetite for risk, I would have a value tilt in my portfolio. If you subscribe to my views (inflation will continue to come down, but the road back to 2% will be long and arduous), the conditions are lining up to be nearly perfect for value vs. growth,
Now to the possible home-run. If you, unlike me, believe inflation will drop pretty fast, and so will the cost of capital (i.e. interest rates), and you happen to be right, long duration stocks is where you should park your money. The cost of capital is a critical factor for young growth companies that do not yet make a profit. These companies – long duration stocks as they are called – have had a torrid time the last two years, but they will most likely come back big time, should the Fed begin lower the Fed Funds rate aggressively again.
Whatever option you go for, allow me to make a couple of points to wrap it all up. First and foremost, should the US economy fall into recession, I don’t expect it to be particularly harsh or long. The Fed’s mandate was changed a few years ago to include full employment, and you should expect a series of rate cuts from the Fed if a recession is suddenly on the horizon. I should also point out that such an outcome favours growth stocks over value stocks, all else equal.
Secondly, let’s go back to Exhibit 4 for a moment. As I pointed out earlier, a rising spread between CPI and PPI is good for corporate profit margins. As long as that spread stays elevated, corporate profitability will benefit, recession or not. On the first signs of recession, you should therefore keep an eye on this spread, as corporate bottom lines may not be as badly affected as one might otherwise expect.
Niels C. Jensen
21 April 2023