The market is digesting two big themes. The first, and most important, is the economic cycle. Will the Fed be able to combat inflation without throwing the economy into a tailspin? The general opinion from professional investors and economists is not a snowball’s chance in hell.
To understand why the market is so skeptical, we offer this highly simplified review of the Fed’s job and some relevant historical context.
Unwanted Job Description: The Fed’s role is to use interest rates and other tools to “manage” the rate of U.S. economic growth. Its two objectives are to create the conditions which permit the highest possible level of employment and simultaneously to prevent excessive increases in prices for goods and services. Unfortunately, there is an inherent tension in these objectives. The closer the Fed comes to hitting the highest possible level of employment the greater the likelihood wages will rise too fast. Meanwhile, the “tool” for calibrating growth, of raising or lowering interest rates, just isn’t that precise. Imagine parking an aircraft carrier in a narrow bay by adding or removing water from the ocean.
Important context: Way back in 2008, the Fed cut interest rates to zero. At the time, the Federal Reserve was trying to defibrillate the economy back to life from the near-death experience of the financial crisis. Zero interest rates were basically the equivalent of maximum support, or flooding the bay, to continue the above analogy. This extreme tactic (along with others) ultimately proved to be successful. The financial system did not collapse, and the economy grew again. Maximum stimulus could not be sustained indefinitely, however, and the Fed was in the process of unwinding the no-holds-barred stimulus during 2019 when the Covid panic started.
Mask over your eyes: The Covid-panic meant that all pretense of discipline exited management of the economy. The Fed cut rates back to zero again. The government authorized $5 trillion (source) in new spending over two years. Billions were sent in direct payments to consumers, unemployment because more lucrative than working, rent became optional, and student debt payments were suspended indefinitely. Billed as a response to demand destruction related to Covid, this massive overcorrection generated a huge surge in price-insensitive consumer activity. Add in increased costs and delays related to covid-restrictions and what do you get: the highest jump in prices seen in the U.S. in 40 years. The aircraft carrier is docking on Everest.
How can the Fed “tap the breaks” without turning employment lower? The Federal Reserve started raising rates and draining water from the ocean last month. It is promising to move quickly with more rate hikes over the next two years. However, it is very difficult to see how the self-reinforcing cycle of higher prices for labor and goods will slow (let alone reverse) without reducing employment and destroying economic demand. Hence, the market is convinced economic contraction is coming.
On the other Hand, Everything is Just Wonderful Now
Complicating any investment approach is what’s happening today. We have spoken with dozens of consumer companies over the past two months what we’ve learned is that business is currently very strong. There was disruption in consumer behavior due to Omicron fears. There are also some concerns about lapping demand created last year in March when large stimulus checks were distributed. Overall, however, consumers up and down the economic spectrum have been out spending even as gas and food prices spike higher. Given that employment metrics are hitting the best levels in fifty years or more, this shouldn’t be too surprising.
Companies are still racing to hire additional employees. If financial markets are all thinking ahead to recession, this is not how companies and management teams are behaving. Everything is still full speed ahead as businesses invest capital in new projects, technology and staff up. If things are about to turn south, then we are very far from the bottom, given that the downturn hasn’t even started yet.
On the other hand, if the elusive “soft landing” is achieved, beaten down discretionary and growth stocks will rebound sharply. As the Federal Reserve attempts to fan the aircraft carrier into port, there is small chance it will be successful reducing demand and inflation without throwing the entire economy into contraction. No one we speak to believes that, but stranger things have happened.
Is Deglobalization the new Risk Factor?
The second theme investors are considering started with Covid but really gained momentum with the Ukraine invasion. We’ve seen a fracturing of the “world-wide” web. The world’s 11th largest economy is getting unplugged. Suspicion of trade partners is increasing. Are we heading towards a world where having operations or customers in multiple countries and regions is viewed unfavorably? This is what some are suggesting. The implications of such a pivot would be very bad, in our view. Consider that between 30% and 40% of the revenues of the 500 largest U.S. companies come from outside the U.S. The ability for U.S. businesses to export products, services, and brands has been a key growth factor for the U.S. economy. Meanwhile, the U.S. has been importing annual goods worth more than $3 Trillion, representing 15% of U.S. GDP. It won’t be easy to replace this volume. Here’s our opinion: Russian may be the new Iran, but this will not spark an unwinding of a multi-decade trend towards globalization. Our apologies to those who blame globalization for climate change and social inequality. It’s here to stay.
Selected Investment from Client Portfolios: What Can You Own Going into a Recession?
It’s a lot easier to identify what NOT to own. The pre-recession playbook is to sell shares of cyclical companies (including consumer discretionary names), high multiple stocks, and those of speculative unprofitable businesses or where balance sheets are indebted. In place of these, investors are buying counter cyclical or defensive names including discount and food retailers, among others. These moves have pretty much already happened in the market.
Generally, we try not to anticipate macroeconomic trends and events like recessions. We may have an opinion about what’s going to happen, but we recognize our ability to forecast the economy is basically nil. Instead, our approach is to look for exceptional companies with solid financial positions that withstand or even benefit from difficult economic environments.
One group of stocks that we feel comfortable owning regardless of macro remains large technology names (among them Google (GOOGL), Facebook (FB), and Microsoft (MSFT)). A friend of ours Evan Tindall of Bireme Capital, recently wrote an excellent and easy to read case for owning Facebook, which we are sharing here with his permission. It is much better than what we included in our February newsletter. FB shares have recently started perking up and we continue to believe the stock is exceptionally attractive.
A clearly defensive name we own is Costco (COST) which has been in our portfolio since inception (8/20/18). We like COST for its unwavering execution of its business model, which includes operating its stores ultra-efficiently and providing value to its customers by charging a razor-thin markup of only 14%-15%. This strategy has enabled COST to acquire customers and grow its business for literally decades. Further, the company’s high penetration of non-discretionary products (grocery) means that its performance is somewhat insulated from big economic swings. Reflecting this, the stock recently recovered to near an all-time high. COST shares are not cheap at current levels (a P/E of 43x FY22 EPS) but we’re not selling.
Figure 1: Non-discretionary stock gains. COST two-year chart. COST has been both a growth stock and a defensive name through several cycles.
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John Zolidis
President & Founder
Quo Vadis Capital, Inc.
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.
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