Recession Pessimism is in Full Force but Most Companies Will be Fine
A brief rally in early June came to a screeching halt late last week. The culprits were terrible consumer confidence figures and a 40-year high reading in inflation data. Prior to these figures, there had been some hope in the market that prices had peaked. Hope did not survive the data. What’s behind the skyrocketing prices for goods and services? The easiest way to frame it is that rising prices are a function of a supply-demand imbalance. Demand was over-stimulated in the hypochondriac overmedication in response to Covid19. Simultaneously, supply is constrained as ripples continue from Covid lockdowns and restrictions. The Ukraine invasion has meaningfully added to the problem by further curtailing supply and adding costs.
A couple things we got wrong at the end of 2021. We believed and wrote in several letters last year that inflation was not transitory. This was correct. What we failed to anticipate is that the Fed response would be aggressive monetary tightening with catastrophic consequences for equity prices. A second assumption we made is that employment would be more important for consumer spending than inflation. In other words, higher prices wouldn’t stop spending provided that jobs were still there. While this has mostly been correct, the consumer is still acting weaker than we would have predicted. Of course, we weren’t factoring in the Ukraine invasion which is negative for sentiment even before its impact on prices.
Everyone Thinks the Fed is Hapless and Behind the Curve
Last month we wrote that the Fed had already decided a recession was preferable to runaway inflation. Of course, we don’t know if the Fed decided that. It’s just our interpretation of various statements and actions from the agency. Nevertheless, if given the choice we’d agree. A recession is preferable, provided it is mild in nature and short in duration. Most people will keep their jobs and companies that deserve to survive will make it. The best companies will exit the recession stronger than they entered, and that’s where there’s an opportunity from an investment standpoint.
A reminder on data. It is backward looking. The Fed cannot do anything about inflation that has already occurred and was reflected in last week’s data. It’s already baked in. The Fed is using its tools to engineer slower demand in the future (in the hopes that this will contribute to easing prices). It will take some time for this pivot to show up in the data, which is not the same as saying its actions are having no effect. In the meantime, the market feels more reactive than forward-looking as it responds to what happened in the past.
Consumers and companies are starting to behave differently. In the chart below, we plotted consumer confidence (red line) against average U.S. gasoline prices (blue line). Prior to the Covid-panic, confidence was at a 10+ year high and had been in a steady uptrend since the 2008-2009 financial crisis. Unsurprisingly, during the covid-panic confidence sank. But does it make sense that consumer confidence today is back to the same levels it hit during the depths of the financial crisis? Unemployment today is 3.6%. During the Spring of 2009, unemployment was 9.0%. Consumer incomes today are still solid. What’s different today is the price of goods (together with the negative media, the stock market and Ukraine).
Demand Destruction is Already Underway
If inflation is a function of supply and demand and consumers are in the dumps, then it follows that demand will slow. This is the main point we want to make in today’s letter. We’re not economists but in our role following the retail industry, we hear that inflation is causing consumers to reduce or change purchasing activity. That’s what major retailers are saying, even though this is not occurring across the board. There is also some noise to interpret as we are lapping the spending of stimulus checks from last year. However, it’s clear that something has changed even if it is not yet in the official “data”.
There is a saying in the oil and gas industry that the cure for high oil prices is high oil prices. High prices in the oil industry encourage more production (adds to supply) and hurt demand, ultimately “fixing” the problem. Might high prices all around be the cure for high prices? What about consumer push-back, at least in discretionary categories? It is widely predicted by retail management teams that discounting and promotional activity (lowering prices) will increase as 2022 progresses. The reason is that inventory levels are catching up (supply is finally working through the Covid delays) and demand is less robust. Wouldn’t this be exactly the solution that the Fed is trying to engineer?
Two Scenarios, one Bullish, the Other Less So.
With consumers feeling bad, and sales of certain categories seeing pressure, we could argue that the Fed’s work has already been done. Demand is easing, which is one of the requirements to bring down prices and snap the inflationary spiral. It wasn’t in last month’s data because it is still on the come. Nevertheless, it is happening. If it continues, it will appear in future data. This in turn will diminish the need for further aggressive rate hikes, thereby allowing stocks to stabilize and potentially rebound. In this scenario, if you are a seller of stocks now, you will be kicking yourself in six to twelve months.
The less bullish scenario holds that the labor market is next part of the economy to crack. There have been sporadic layoff announcements but as mentioned above unemployment was recently at 3.6%, near all-time lows. The Fed has stated it wants to reduced demand without a recession, but the extremely tight labor market is one of the main contributors to rising prices. Slightly higher unemployment would be okay, but inciting companies to act defensively, cancel capital spending projects and cut costs by reducing staff levels is something else entirely. Future estimates for company revenues and earnings are not factoring in this scenario. If it occurs, the Fed will have achieved its aim of squelching inflation, but at the cost of a lot of financial pain across the spectrum, including more downside for stocks.
How We are Managing Investments* During the 2022 Inflation Spiral and Rate Recession
Predicting the path of the economy remains difficult if not impossible. We try to keep an eye on what’s happening, but our forecasting ability is limited. One reason is that unexpected things happen, such as Covid19 and the Russian invasion of Ukraine. What will be the next unusual event that affects markets? Honestly, we have no idea whatsoever. Instead of spending time contemplating unknowables, examining backward-looking macro data, or trying to judge whether today’s valuations for the S&P 500 make sense relative to the past, we focus our efforts on finding great companies. We look for businesses with strong financial positions, top management teams and durable competitive advantages. Ideally, we want to buy the stocks of these businesses opportunistically and own them for the long term. In the current market, we are finding many high-quality names that are down 50% from recent highs. This makes us more bullish about future investment returns, even if (or because) near-term uncertainty is elevated.
*Talk to your financial advisor about what is appropriate for your investment and risk profile.
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John Zolidis
President & Founder
Quo Vadis Capital, Inc.
John.zolidis@quovadiscapital.com
Mr. Zolidis founded Quo Vadis Capital, Inc., a Registered Investment Advisor (RIA) and research consultancy, in 2017. He started his career in finance in 1996 following degree studies in Philosophy at Kenyon College and the University of Oxford. He has followed U.S. consumer companies as a senior analyst since 1999, mostly on the sell-side, writing research for institutional investor clients. He also managed money in a buy-side role at a long-short equity fund over 2013-2014. He was named in the Wall Street Journal’s Best on the Street list in 2005. Mr. Zolidis and works from New York, NY and Paris, France or wherever he has his laptop.
This month I am attending the Viva Technology conference in Paris. Viva tech (https://vivatechnology.com/) brings together executives from major multi-national technology and consumer products companies with entrepreneurial leaders, investors and others. We have a couple of objectives at the conference. The number one thing we are learning more about is the metaverse, which we approach from an investing standpoint. Secondly, we want to learn about other big picture technology changes and trends, especially as it involves the consumer and operations for consumer companies. Lastly, we like chatting with small startups, especially in tech, as it’s inspirational to spend time with people focused on innovating and developing innovative solutions to problems.
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