It now appears inevitable that inflation will rise higher and persist for far longer than most expected even just a few months back. Prices are rising across the board worldwide, driven by both supply and demand issues.
On the supply side, pandemic disruptions continue to linger, compounded by spillover effects from the Ukrainian war and, increasingly, export bans by countries for critical food supply. Demand, on the other hand, is still relatively robust, especially in the US, spurred by the reopening of economies. As we have articulated previously in this column, US households, on average, are in good financial shape. Household debts remained near the lowest levels in nearly two decades. Consumer spending is buoyed by massive government handout and trillions in excess savings during the pandemic as well as the positive wealth effect from years of rising asset prices, since the global financial crisis. For now, consumers appear comfortable to continue spending, outpacing inflation, and dipping into their savings.
Hardly a day goes by without inflation hogging global news headlines. More and more, we are reading of that dreaded word — stagflation. For some, the current environment harks back to the 1970s, when rapid inflation necessitated high interest rates, resulting in anaemic economic growth and rising unemployment that persisted for many painful years.
Supply disruptions and shortages are, by and large, beyond the control of central banks. China remains steadfast in its zero-Covid policy and stringent lockdown measures. The war in Ukraine is turning into a protracted conflict with no end in sight, given the constantly changing and increasingly divergent expectations of what victory — for either Russia or Ukraine — even looks like.
That leaves the US Federal Reserve with little option but to tighten — aggressively — and, in the process, forcing the rest of the world to follow suit. The Fed has been talking very tough, indicating consecutive interest rates hikes, in 50-basis-point increments no less, plus shrinking its balance sheet for as long as necessary to crimp demand and bring down inflation — even if it means higher unemployment and risks tipping the economy into recession.
In fact, we suspect that markets, being forward-looking, are already pricing in a recession scenario, on top of higher interest rates and reduced liquidity — hence the steep sell-off in expensive, high-growth tech stocks, especially those burning cash. Mathematically, interest rate changes will have an outsized impact on growth stocks, given that the bulk of their earnings are further in the future.
Tech companies that rely on cheap, free flow of capital and high-priced shares to fund their customer acquisition and growth will suffer the most — when liquidity tightens and costs are rising. Pressure is mounting for these companies, not just on how to keep growing sales but, importantly, turning sales into profits. And many are finding that they have far less-than-expected market pricing power. We have previously written about price elasticity of demand for tech disruptors that embraced the “growth at all cost” strategy. Indeed, even for the broader market, winners and losers in the near to medium term may well be differentiated by their respective pricing powers, and price elasticity of demand.
Can the Fed successfully tread the fine line and engineer a soft landing for the US economy? Recent disappointing earnings from retailers Walmart and Target — owing to falling margins on the back of higher costs and inventory markdowns — suggest that demand may indeed be softening. Discount retailers Dollar General Corp and Dollar Tree, on the other hand, reported a better outlook — further highlighting a possible consumer down trading and spending shift to essentials as inflation bites.
The massive wealth destruction — the combined market values for stocks, bonds and cryptos have fallen 14%, or US$27 trillion ($37.1 trillion), so far this year — must have some impact on consumption. On a slightly more positive note, considering that the wealthiest 10% of Americans own some 89% of all US holdings of stocks and mutual funds — and the bottom 90%, about 11%, according to recent Fed estimates — the impact is likely to be less than the headline drop suggests. To begin with, the rich has lower marginal propensity to consume and are less affected by falling asset prices and inflation.
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The housing market bears close monitoring, though. Home ownership is much broader in the US — with the bottom 90% owning 55% of all real estate in the country. Somewhat ironically, the Covid-19 crisis created a housing boom. Since 2020, home prices have surged and near-zero interest rates fuelled refinancing and home equity extraction. This, in turn, boosted household wealth, paring debts and/or boosting spending power. This trend, however, is reversing.
The sharp rise in mortgage rates in recent weeks has cooled frenzied buying activity — new-home sales have fallen every month so far this year. And more sellers have emerged, on the growing belief that the housing market may have peaked. We think it unlikely that there will be a crash, at least in the near-medium term, though moderating home price escalation could take the wind out of consumption.
In short, there are reasons for the cooling of the US economy — and early signs of it. As we mentioned, markets appear to be pricing in a recession. Bond yields have fallen off their recent peak in early May — stabilising prices are a sign that recession fears are driving a return of investor demand. We are also reading about a growing number of companies signalling slower-freeze in hiring, or worse, layoffs — though the overall job market remains tight. Only time will tell whether the economy will slow or fall into recession, which, typically, can be confirmed only with the benefit of hindsight. Positively, the pace of inflation may be moderating but is likely to stay high for some time yet.
While markets are pricing in recession, we think the analyst community, by and large, has not. Despite rising costs and growing demand uncertainties, underscored by the amount of cautionary guidance from managements, forward earnings expectations have actually inched higher this year. Earnings for the Standard & Poor’s 500 stocks are still expected to rise 10% this year, according to data compiled by FactSet. Current forecasts for margins remain well above pre-pandemic levels and historical averages. Therefore, although stock price-to-earnings valuations have fallen with the market sell-off, stocks may not be as cheap as they appear to be (see Chart).
This, we think, is the reason for investor caution. It is also why we think the bond — instead of stock — market may be nearer the bottom. And it is also the rationale for our adding the iShares 20+ Year Treasury Bond ETF, which tracks an index composed of US Treasuries with maturities exceeding 20 years, to the Global Portfolio.
For this reason, too, we see more downside for US equities. Part of the current “cautious optimism” is down to the belief by many that the Fed will slow the rise in interest rates with signs of economic slowdown, even if inflation figures remain stubbornly high. We do not share this “cautious optimism”. We simply find it hard to believe the Fed will reverse course so easily. If nothing else, credibility is at the heart of all central banks.
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Back in early April, we reduced our US equities exposure in favour of Chinese stocks. China had tightened monetary policy earlier and is now in a different cycle from the US. The switch is paying off. New additions to the portfolio, Guangzhou Automobile Group Co and Yihai International Holding Ltd are up 16.3% and 20.6%, respectively, while Postal Savings Bank of China Co is down 12.9%. Including Alibaba Group Holding, our investments in Chinese stocks are up by 3.9%. By contrast, our US stocks (excluding Amazon.com, which we have since disposed of) are down by a combined 16.7% in value.
Sidebar Article: The punters are also ‘smart money’
We have explained in the main article why we think US stocks could see more downside from here on, and why the bond market may be nearer bottom. As such, we invested part of our funds in the iShares 20+ Year Treasury Bond ETF last month. This exchangetraded fund tracks an index composed of US Treasuries with maturities exceeding 20 years. As it turns out, we are not alone.
Last week,The Wall Street Journal carried an article titled “Main Street investors break records in rush for US government bonds”. It noted that, from meme stocks to cryptos, retail investors are now pouring record amounts of money into mutual and ETF funds focused on US Treasuries, as well as inflationlinked government savings bonds (see Charts below).
Charts by: US Treasury Department via WSJ
- End of Sidebar Article -
The Global Portfolio closed 5% higher for the week ended June 1, recouping some lost ground from the broader market selloff. The biggest gainers were Alibaba (+14.9%), Yihai International (+13.4%) and CrowdStrike Holdings (+10.1%). On the other hand, Postal Savings Bank of China (-3.2%) and iShares 20+Year Treasury Bond ETF (-2.6%) ended the week in the red. Last week’s gains lifted total portfolio returns to 31.2% since inception. The MSCI World Net Return Index is up 42.2% over the same period.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
