Consumption is the crisis. Market doesn’t get it!

Blain’s Morning Porridge – Jan 16th 2023: Consumption is the crisis. Market doesn’t get it!

“We’re going to need a new kind of leadership that is more agile!”

This morning: Consumption and a cost-of-living crisis are upon us, but markets blithely assume it’s all upside to 2023. The risk is not a massive crash, but growing realisation the global economy has peaked, needs a period of normalisation and a reset after the madness of the last decade.

 A successful, thriving economy is a wonderous thing. Life gets better, companies become more valuable, the population becomes wealthier – spawning a virtuous cycle of consumption as rising incomes drive up the demand for goods, causing company earnings to increase, triggering invention and innovation, new products, markets and wealth creation, enabling companies to pay workers more and give higher returns to owners. Everyone has more to spend.

It’s really quite simple. At the base of a successful economy are growth and productivity gains – but the key factor is consumption. The value of an economy and growth depends on how much it is producing – how much more it produces depends largely on how much more productive it becomes – and how the goods produced translate into rising incomes and rising overall consumption.

That’s the broad theory. The devil is in the detail.

It’s no wonder the World Economic Forum (WEF) – about to host the Davos gabfest of billionaires, bankers and politicians – is warning a Cost of Living crisis (in other words, collapsing consumption) is the biggest threat to the global economy. They could also have said income inequality is the killer: if the 1% get to keep all the money, then everyone else starves – but that doesn’t really gel with the Davos vibe of billionaires wanting to save the world…..

(Quick spoiler: on the basis mentioning WEF means I might simply be one of their pawns and enablers, let me demonstrate my anti-WEF credentials: WEF exists to say exactly what is wrong with the global economy and how to fix it. That’s absolute genius: we then credit the very guys who’ve created the problem with identifying it, and are then quite happy to sit back and let them solve it… which they won’t. (But I won’t say that, because it might sound like mad, bad, conspiracy theory…))

The trick to the growth cycle is the flow of capital around the corporate growth engine. When capital is there to support and encourage innovation, productivity gains and growth all work rather well. But a key issue is cost of capital. It’s simple to see that if the cost of capital is too high, then companies can’t afford to pay for productivity gains – ie new plant, machinery or products. Raising interest rates is like plunging the rods into a nuclear power plant; it slows the economy, and cuts inflation (too few goods chased by too much money – make money more expensive and less plentiful!)

What is less understood by the mainstream is the danger of over-plentiful capital. Everyone understands if the cost of capital is too low it causes inflation. But it has other significant effects – it misprices risk. Hence the last 15 years of cheap capital, the QE ERA, spawned massive speculation as cheap capital was redirected to enable all kinds of fantabulous growth in new sectors and changed the way corporates invested in growth.

We saw a rising investment belief that profits didn’t matter. Rising stock prices, fuelled by FOMO and ultra-low rates became a force in its own right. We now know investing in profitless companies and concepts – from Fintech, electric scooters, space tugs, crypto, NFTs, office rentals as tech, etc, etc, was a hiding to nothing. Guess what these companies are worth now?

More insidiously corporate behaviours changed. If capital is free, why invest in risk? Why risk uncertain returns from building a new plant, when the value of the company could be hiked higher through stock buybacks funded with debt – with the incidental effects of pushing up management renumeration and keeping wage costs low.

All of which brings us to this morning… 16^th January, 2023.

We’re all aware global markets had a miserable 2022 – the Ukraine invasion energy shock igniting global inflation, increased shock fears of war in Europe and Southeast Asia, soaring interest rates, crashing bond prices and equity bubbles bursting. Unfortunately, there is not a market rule that says “things can only get better.”

If I look at any chart of global equity prices since 1945, its kind of obvious to me we’ve just seen the third wave, the third big bull market – and even committed chart sceptics, like myself, know the classic Elliot Wave theory propounds three up-waves before two down-waves back to mean reversion.. (which might be over-simplifying it – a bit, but I’m sure you get the drift…)

For the last two weeks we’ve seen the markets of 2023 opening on an uptick. Falling bond yields and rising equity. Lots of talk about indices reaching new highs. Analysts saving stocks are already back to fair value. (Under what metric??) I am told discredited stocks are back on the way up. Even Tesla is set to double according to a number of firms – apparently! (I’ll have a quarter of whatever these guys are smoking please.)

What’s changed?

• That US inflation last week was a smidge less strong than expected – which apparently means no recession, US interest rates will undoubtedly stop rising as fast and will definitely fall later this year, meaning it’s time to jump into the market now before it’s too late.. ??
• China, after a mildly chaotic (and frankly confusing) reversal on Covid, will reopen strongly, boost global trade, and is showing greater willingness to re-engage with the west after it observed Russia’s failure in Ukraine. (yep, that makes more sense.)

That’s the way it sounds.. All I can say is … caution.

Thing is.. Investment Bankers don’t get rich by being cautious. I am hearing stories from across the big US Banks and funds, about bonuses being slashed. Apparently 40% of staff at a leading US firm got zero bonuses. That’s because deal flow died in 2022. The only way anyone gets paid this time next year if is deal flow returns, and that only happens if folk think this market is set to rally. Fund managers only reap fees from savers if they get that savings money..

As I said.. bankers don’t get paid for being cautious..

Inflation will fall. The energy inflation shock was just that – a shock. Prices are normalising. The world may not now go into a devasting stagflationary recession.  What is not normalising is the economic lethargy and embedded inflation – as workers fight to restore their real wages after a decade of zero real income growth, and then the inflation spike. I simply don’t see inflation returning to sub 2% except on a real inflationary economic bust ( a deep recession)

More likely is:

• Stubborn wage inflation, the “great resignation” and high employment keeping it in focus,
• Repressed consumption and the cost-of-living crisis keeping sales constrained thus limiting earnings,
• Rising concern on government and personal debt levels – keeping rates high,
• Weaker US dollar on political impasse, potential default,
• Economic problems in China reducing the growth multiplier effects of a reopened economy,
• Interest rates normalising around 3-4% long term,
• Stock markets range trading then reassessing the long-term outlook and concluding earnings multiples for mature businesses in double digits make zero sense

What I am not expecting is a massive market sell-off or crash – just growing realisation that is a new normal.. In such an environment I’m favouring selective equities, government bonds to lose less money than credit or equity, but would prefer to be invested in real-yield solid cashflows on the basis I expect inflation to find a new steady normal level. Hope that makes sense…

As a quick aside, I’ve been thinking about the market all weekend. It doesn’t depress or scare me – there are times when the market outlook has terrified me. This just looks “inevitable”. I spend a rainy Saturday afternoon throwing paint at a canvas, trying to make sense of it all. What emerged in my final picture – which is this morning’s photo – is a dark, confused scene. Storm clouds yet a peaceful calm sea.

Confusing and contradictory.

Five Things To Read This Morning

FT                    Top Global companies write down billions as deals make way for gloom

Investment Week       Model portfolios are no longer fit for purpose

WSJ                 Economists in WSJ Survey Still See Recession This Year Despite Easing Inflation

BBerg              Energy, Chips, Taiwan: Flashpoints for 2023 in a Fractured World

BBerg              Mortgage Market is a Bright Spot in UK Cost of Living Crisis

Out of time, and back to the day job…

Bill Blain

Strategist – Shard Capital