Inflation and Recession

Open: Tony: Active management's about studying history, studying the current data but then adding judgment to that because data and history doesn't see around corners, human judgment does. And that in nutshell is how we can add value as active investors.

Intro: Welcome to this special edition of The Bid meets our Expert-to-Expert investing series from our Fundamental Equities group. Today we’re bringing together two investors from different generations to examine the factors shaping the outlook for the U.S. stock market from their different vantage points and experience.

I’m your host Will Su, Co-Director of Research for the U.S. Income and Value team. And I’m joined today by my colleagues Tony DeSpirito, CIO of U.S. Fundamental Equities, and Caroline Bottinelli, Co-Portfolio Manager with our U.S. Growth team.

From inflation to sustainability, together we’ll dig into the topics on investors’ minds and, in the process, debate how expectations for the year ahead may be colored by time horizon and our own experience of market history. 

Tony, Caroline, welcome!

[00:00:00] Will: When you have a year like 2022, the tendency is to look to history for a comparison, for some insights or lessons or patterns, something to help guide your investing playbook. But 2022 has really been an anomaly in so many ways. So I'll start by asking each of you, how has your own experience or study of history shaped your view of the markets this year? 

[00:00:23] Tony: Well, I'll, I'll start with that, Will, I think history's incredibly important. And as both of you know, Larry Fink often talks about the importance of being a 'student of the markets'. And part of that is being a student of market history. given today's topic, I figured history would come up, so I brought with me two quotes that I wanted to share, so I'll read them. 

 One is from Winston Churchill. He says, The farther back you can look, the farther forward you are likely to see. And I think that applies to a range of fields, obviously politics, sociology, but also markets. And then John Kenneth Galbraith specifically talking about markets says For practical purposes, the financial memory should be assumed to last at maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on a previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene impressed as had been its predecessors with its own innovative genius and he's talking a lot about financial bubbles, and that's how he relates that quote. 

So I absolutely do think studying history is important and on our team, in 2021 when we saw inflation starting to increase, we went back and asked all our analysts to study the 1970s, cuz that was the last bout of significant inflation. And not only did we ask them to look at stock returns and and stock prices, but we also asked them to go back and read 10 K's to read what management was saying in their reports year by year, and to see how that inflation impact evolved. And that really helped us set our playbook for this year. That's really what active management's about. It's about, studying history, studying the current data but then adding judgment to that because data and history doesn't see around corners, human judgment does. And that in nutshell is how we can add value as active investors. 

[00:02:14] Will: Our fundamental equities group surveyed over a thousand U.S. Individual investors in the first half of this year, and it was interesting to see the differences in views by generation. The younger investors, the millennials, were more comfortable adding to their equity allocations this year. So Caroline, as a fellow millennial, what do you make of this phenomenal? 

[00:02:33] Caroline: Well, I think there are two factors at play here. The first is that investors of my generation just haven't seen a period of sustained high inflation in their lifetimes,. As the forces of globalization and technology and demographics have put downward pressure on inflation and rates over the past 40 years. And since we've been in this environment of tame inflation for so long, we've grown accustomed to the Fed being quick to pause or even pivot at the first signs of economic weakness. And so I think because of this experience of relatively recent history, younger investors are maybe more inclined to believe that, the Fed will pivot here, which would be positive for equities. The second, and I think the more important factor at play here is this younger generation has a longer investment horizon. 

So sure, equities could fall further from here but over the long term, its earnings compounding that drives returns, and we know that missing out on just a handful of the best days in the market can significantly negatively impact those returns, and so it's important to stay fully invested. As they say, it's time in the market, not timing the market. 

[00:03:49] Tony: I, I think that's great wisdom. I've lived through multiple bear markets, right? 1990 2000, 2008. And at the time they all seem massive they're quite frightening to be honest. But when you get some historical perspective, they start to look like small speed bumps on the way to good long term returns. 

And t hat's the power of compounding, right? That's your point about staying in the market. It's time in the market, not trying to time the market. And so you look at this year and the market's down about 25% through the third quarter. Earnings estimates have actually gone up over this time period, so the multiple contractions even greater and it doesn't feel good. 

But reality is stocks are on sale. Could they go down from here? Absolutely. But I think once we get some time between now and, and then and get some hindsight, this will look like an attractive opportunity to be adding to equities. It reminds me of my own experience in 2008, I started to increase my equity exposure in October. 

Was that early? Yes. But with hindsight, those were great investments that I was making at that time. I think that's the lesson. 

[00:04:55] Will: One thing that all the respondents in the survey agreed on was that inflation. Biggest risk to stocks over the next six months, and certainly inflation and higher rates have been particularly hard on growth stocks. So Caroline, as a growth manager, what's your outlook for growth stocks at this moment? 

[00:05:12] Caroline: The pandemic, no doubt created excesses, for example, in the spending on goods over services, and some of those excesses are now being worked off and combine that with higher rates, which disproportionately impact growth stocks as longer duration assets, and some of this repricing was warranted. That being said, we're long-term investors and the secular tailwinds that we're investing behind continue. Whether that's the trend toward eCommerce or public cloud adoption or automation, innovation is not slowing. I'd also add that the odds of a recession, have increased and recessionary environments tend to favor growth stocks just given a scarcity of economic growth. The macro is highly uncertain here, but evaluations for growth stocks in particular have come in and the sell off has been pretty indiscriminate, which I do think creates attractive opportunities for active managers to pick up quality growth stocks with secular tailwinds and with pricing power to manage through a potentially inflationary environment for a longer period of time at a now attractive. 

[00:06:23] Will: And then Tony. It's a different story for value stocks, right? Which is what you specialize in and value tends to outperform in higher inflation regimes. So are you concerned that value could fall out of favor as inflation recedes 

[00:06:36] Tony: So I'd go back to the history, and I think it's important to keep in mind just how unique the decade after the global financial crisis was, It was a period marked by really low growth, really low inflation, and really low rates. That's a tough time on a relative basis, at least to be a value investor, right? So value stocks went up during that period, just a lot less than gross stocks or the market. While I do see inflation rolling over from here, so I think it's very likely inflation is peaked and is coming down. I don't see it going back to the levels of the post global financial crisis era for a couple of reasons and one is I think there are just some structural things in place that are just gonna mean higher inflation. 

It's some of the things you mentioned earlier, Caroline, the deglobalization decarbonization as well as demographic changes. All those lead to higher inflationary forces. So I think we're, as investors, it's not our job to look at the last decade. It's to ask what's the next decade gonna look like? 

And so I think that's gonna be one that's much more favorable to value investing. Also starting points matter. And one of the things that we look at is valuation spread. So value stocks are always statistically cheaper than the market, but how much cheaper varies over time. So sometimes those spreads are pretty narrow and sometimes they're really wide. 

As we sit here today, Those spreads are very wide. In fact, statistically you'd say two standard deviations wider than normal. So Caroline's just told you why growth stocks are interesting. I just told you why value stocks are interesting. How do you square that, right? I think that's a natural question. 

We went back and looked and said, What if you took a portfolio of growth stocks and a portfolio of value stocks and blended them 50:50 and then compared that to investing in the market? And what is that growth and value blend is actually very cheap versus the market today. 

So what that's telling you is the stocks in the middle are actually very expensive, and historically from this starting point, you do really well blending that growth and value.

[00:08:37] Will: So let's talk about the risk. So we did the survey of investors in January, then again in May, and inflation was cited as the top risk both times it's October now. Do you think inflation will still be the biggest risk to stocks in the next six months? 

[00:08:52] Caroline: I do, because I think it's inflation that's ultimately driving the Fed's rate hikes. Of course the Fed is going to talk tough on inflation because they need the market to believe that inflation will not be persistent. But the reality is that. If inflation begins to moderate, it gives the Fed room to pause. 

My concern is that the inflation that we're seeing right now is supply driven and broad based, and we have this very tight labor market, and I think it may be difficult for the fed to tame inflation with the tools that they have without causing a recession. 

[00:09:29] Tony: Yeah. From my perspective, if you go back to the beginning of the year, I had two concerns, One was the fed was clearly behind the curve in raising rates. So I think spiraling inflation was a real risk at the beginning of the year. The other risk was they'd tighten significantly and that could cause a recession. 

Obviously, the Fed's goal was right up the middle, soft landing. Although history, would tell you don't expect a soft landing. The only soft landings we've ever seen have been when the feds ahead of the curve, not behind the curve And so you fast forward to today, the Fed's actually done a lot of work since then we've never seen such dramatic or since Volker, we haven't seen such dramatic rate hikes in such a short period of time. 

And we all know rate hikes affect the real economy with a lag at least six months. But most economists would tell you something more like 18 months. And so I think there's a strong likelihood that the Fed overshoots and that we do end up in a recession. And in the portfolios I've run, we've lowered the beta of those portfolios in an effort to protect ourselves from a potential recession.

[00:10:30] Will: Let's shift gears to sustainability. In our survey, millennials have shown the greatest interest in sustainable investing than either Gen X or Boomers. And it's certainly a newer and growing area of investing. So as active investors, and I'd be remiss to point out that one of the three of us is a ESG professor here, how do you define the investing opportunity in sustainability here? 

[00:10:53] Tony: So I'm really excited about the alpha potential and I think that's important to emphasize the alpha potential of ESG investing. And, I look at it just like I look at other alpha drivers but I do think ESG is becoming an increasingly important driver of Alpha. 

And I think about in terms of it's about companies following consumers, where their minds are at, where they're headed. It's about attracting a talented workforce in helping the company execute on its strategy better, and if a company manages their ESG risks better, they have a lower cost of capital. 

And so all those things generate alpha. And then as an active investor, I think there's a real opportunity for us to go beyond rating agencies coming up with our own ratings of companies based on ESG. And there's also the opportunity for us to think about how companies might improve on ESG to create more value for shareholders to lower their cost of capital et cetera. 

There's also some opportunities to be a little bit more contrarian and a little bit more thoughtful. And, I'm actually gonna bring you into this Will, because you're our resident expert on energy. And I think we've done some interesting thinking on, and positioning around ESG there. So why don't you talk about that. 

[00:12:02] Will: Yeah. Perhaps we can do another episode of the bid to go through the many nuances of energy and sustainability, but in general, I think what unfolds this winter in Europe, is gonna be a pretty watershed moment in this whole discussion. The market's realizing that pushing too quickly into intermittent renewables without them achieving scale first is a recipe for inflation and energy insecurity, And it's a regressive tax for the least financially well off in our society today. I also see, continue to see a big opportunity to invest in natural gas, which has a key role to play for decades to come replacing coal and power generation emitting half the carbon emissions of coal. And finally, some of the largest oil and gas companies today, for as much as they're vilified can play a key role, In two things. They can generate inflation protected dividend income for investors' portfolios, and at the same time with high commodity prices. They can also develop some of the key technologies that we need for them to become the largest renewable energy companies in the coming 1, 2, 3 decades. So another sector that's in the headlines, which is technology, so Caroline Tech and innovation, big parts of growth investing. What do you see for technology stocks as we get closer to turning the page to 2023. 

[00:13:22] Caroline: the technology sector holds a lot of these poster children of growth stocks where the earnings were supercharged during the pandemic and higher rates have had a significant impact on valuations. But I'd emphasize again that the secular tailwinds driving these businesses continue. And I actually think that the challenges businesses are facing today from a tight labor market and higher input cost could drive greater adoption of technology as businesses just look for efficiencies. 

 I'm optimistic about the tech sector as the market rewards earnings growth over the long term, and you do now have a more attractive entry point. But I'd also point out that I think you can find innovation across sectors. for example, healthcare or industrials. And the technology sector itself is a pretty heterogeneous sector. 

So I think that active management, again here is really important and picking your spots is critical. 

[00:14:23] Will: So no matter how much you've seen, studied, or how long you've been investing in the markets, 2022 was an unusual and humbling year for all investors. So what was your biggest learning that you'll take with you as you invest next year and beyond? 

[00:14:38] Caroline: For me, it's the importance of knowing what you don't know. So if we rewind to this time last year, valuations for growth stocks were stretched versus history, and inflation was elevated, and so in retrospect, it might seem obvious that a sell-off in growth was overdue, but you have to remember at the time that valuations for growth stocks had been stretched or elevated, versus history for years. 

And there were all these reasons to believe that the inflation we were seeing at the time was transitory, just a byproduct of these temporary supply bottlenecks. So the lesson for me is that these regime changes or inflection points in markets are just really difficult to predict. And I think our job is to be aware of the risks and to diversify our portfolio. 

[00:15:33] Tony: So when I think about this year in inflation and rates, I think about Dornbusch's Law and the gist of Dornbusch's Law is, in finance or economics, whatever you think should happen, ultimately takes much longer to start happening, but once it does start, it moves at a pace way faster than you would've expected. 

And so I think that's what we've seen with inflation and rates this year. For over a decade the Fed was trying to get inflation up and it couldn't, and then it finally did. And once it did it started to rise at a pace that far exceeded policy makers expectations. And that's a lesson I think we just see over and over in financial markets. 

[00:16:12] Will: We covered a lot of ground today. Tony and Caroline, thanks for joining me. 

[00:16:17] Tony: Thanks.

[00:16:18] Caroline: Thank you. 

Will: Thanks for tuning into this episode of The Bid meets our Expert-to-Expert investing series. For more equity market insights, check out our recent episode “A stock picker’s guide to inflation,” featuring Tony DeSpirito.

On our next episode of The Bid … Mark Wiedman will be back with the Real Leaders of Net Zero mini-series speaking with another CEO who is leading the charge towards a net zero future.

If you’ve enjoyed today’s episode, rate and follow The Bid wherever you get your podcasts.