Fire Capital Market Update - 2Q 2022

“Russia is a riddle wrapped in a mystery inside an enigma.” – Winston Churchill

War is terrible and indifferent to untold humanitarian costs.  The fog of war has been described as the uncertainty in situational awareness that accompanies combat. Much in the same way, markets have reflected a heightened level of uncertainty to start 2022.  It has been many decades since world powers have contended with the prospect of direct conflict.  Coincidentally, it has also been many decades since the global economy has dealt with the prospect of slowing growth, high inflation, and the effects of a protracted tightening cycle.  While history may serve as a reminder in terms of what to expect, it is also not likely that the current state of affairs matches precisely with those of yesteryear.  Accordingly, we feel that more than a moderate dose of humility and prudence is in order as we traverse a highly dynamic and tumultuous landscape.  

Slowing Global Growth Expectations

Following a robust rebound, the global growth outlook for 2022 & 2023 is encountering mounting headwinds.  As the U.S. and China go, so does the world.  For the former, the aid of fiscal stimulus has largely been removed and consumers’ balance sheets are returning to pre-pandemic levels in the world’s largest economy.  Inflation levels not seen since the early 1980s are beginning to impact expectations and therefore spending decisions.  As for the latter, the second largest economy continues to pursue a near zero-COVID policy which slows the healing process of supply chains.  While many parts of the world may be moving into an endemic phase of the contagion, a surge of new cases has led China to effectively lock down Shanghai, their largest city with approximately 27 million people.  Elsewhere, debilitating economic sanctions imposed on Russia threaten to derail economic expansion and stoke inflationary pressures in Europe.  Vital supplies of wheat and industrial metals from Ukraine have been cut off to trading partners.  With this as a backdrop, the potential for a global recession has been elevated.  

Inflation is Hampering Consumer “Real” Spending Power

If inflation becomes entrenched in future expectations, it becomes self-reinforcing through a wage spiral. In the face of a supply chain disruption, inputs are harder to obtain, production slows, inventories fall, and the cost of goods rise. While consumer demand is strong, businesses raise prices to combat these higher input costs. In turn, consumers– the employees of these businesses – impute their salary requirements in consideration of future higher costs, increasing labor costs for businesses and further driving up prices.  Currently, we are experiencing a tight labor market. In such a market, businesses are forced to pay higher wages demanded by scarce workers. These higher wages elevate input costs even further, prices continue to rise, causing persistent inflation, and thus the wage spiral continues to feed itself.

At present, despite strong job and wage growth, inflation is effectively cutting “real” (i.e., inflation-adjusted) purchasing power.  After stimulus-powered surges in 2020 & 2021, personal savings rates is back down to its pre-pandemic levels. With current rates of inflation increasing, real spending power is declining.  When real income declines for sustained periods, aggregate spending also falls and economic activity slows.  However, as a silver lining to our current predicament, an expanding diverse labor force along with increased business investments may serve as the bedrock of the future.          

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Diverse Workforce Implies Robust Employment Market

To start the year, the unemployment and participation rate(s) have improved signaling continued and steady restoration of the labor market.  Led by business investment, job openings remain at elevated levels. March reflected the eleventh consecutive month of job gains in excess of 400,000 – a new record.  Importantly, an increasing labor force participation rate will support potential GDP growth without further overheating the economy.  The added labor supply will serve to dampen inflationary pressures related to wage growth and can curtail a wage spiral.  A diverse set of hiring industries demands a broader range of skills, allowing for a greater number of employable candidates and leading to a more diverse workforce. Ultimately, a more diverse workforce is a stronger, more productive workforce, and should lead to an improvement in living standards. Thus, a robust job market is paramount to sustained “real” economic growth.  

Tightening Monetary Policy Accompanies Inverted Yield Curve

Ordinarily, the U.S. economy would not be expected to enter a recession when the labor market is strong.  However, the Federal Reserve (Fed) has a dual mandate of achieving maximum employment along with stable prices. Currently, policy adjustment to address the latter are of primary concern.  Market participants are anticipating that the Fed will engage in multiple interest rate hikes to battle inflation.  The exact timing and magnitudes of such hikes is up to some speculation, but it is safe to say that the uncertainty surrounding this has contributed to considerable market volatility.  Perhaps late to the party, the Fed’s most recent hike was the 129th central bank move of this global tightening cycle.  Since the Fed’s latest meeting in March 2022, the Treasury yield curve has been flattening dramatically such that U.S. government obligations with a ten-year maturity yield less than those due to be repaid in two years’ time. This flipping of yields is often referred to as yield curve inversion and given the projection that short-term interest rates may achieve nearly 3% by the end of next year, a further inversion of the yield curve seems highly likely.  While there are many potential reasons for this, an inverted yield curve is considered an ominous sign for the economy and markets.  It is worth noting that many recessions throughout history have been preceded by an inverted yield curve.      

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Lower Profits and Higher Rates Should be Reflected in Valuations

Returning to the importance of the consumer, future consumer spending translates to corporate revenue growth.  Expenditures on online retail and home products were pulled forward dramatically during the pandemic.  As the tailwind for the sector has faded, forward guidance for many such companies has been lowered.  As we head into Spring and Summer with lower global COVID restrictions, expectations suggest that future consumption favors more service orientated sectors, such as travel and leisure.  Of note, elevated energy prices stand to derail this as costs for automotive and air travel are already high.  

Higher interest rates also impede economic activity as the cost of doing business increases.  Variable rates, often found on credit cards and student loans, necessitate lower disposable income available to consumers as they increase following Fed rate hikes. Additionally, real estate purchases and financing costs are inversely related.  Mortgage rates are at multi-year highs, and pending home sales are in decline in the face of increasingly high prices.  Higher financing costs negatively impact many businesses as well and lower profits should be anticipated.  As evidence of this, equity valuations at the end of the first quarter reflect a modest discount to the level seen at the end of last year. The focus moving forward is on corporate earnings growth and increasing required returns by investors as the Fed considers future interest rate moves.

Stay Nimble, Know What You Own, and Follow Your Principles

Economic activity may be lower going forward, and inflation has not yet relented.  From an investment perspective, higher interest rates provide an opportunity for attractive bond yields that have not been seen in decades.  Yet, equity ownership in growing, well-managed businesses with quality balance sheets still provides better inflation protection and return potential than bonds.  As we reflect on the current landscape and look to draw comparisons to a time long since passed, we are reminded of another Winston Churchill quote, “I am an optimist. It does not seem too much use being anything else.” Indeed, in times such as these, caution is warranted but perspective on the long term is salvation. Diligent evaluation of prospective investment opportunities and prudent risk management are the hallmarks of our investment process.  In times of extreme uncertainty, we rely on it like a lighthouse’s beam piercing the fog.