Byron Wien: Complacency Gives Way to Uncertainty
- Paul Monroe Domingo
- Oct 15, 2022
- 4 min read
Tailwinds to growth are fading. Headline inflation may have peaked, but it’s sticky, and the Fed will “keep at it” to rein in prices.
A former employer and mentor of mine once described his philosophy for portfolio management like this: Successful investors focus on making the best hand with the cards they’re dealt. The corollary to that statement is that too many people in the investment management industry—managers and forecasters alike—spend their time thinking about the way markets should be. It’s no surprise my former boss excels as a portfolio manager. One must be clear-eyed and dispassionate in order to analyze the cards that the market has dealt.
Today, I’m reminded of that lesson. Growth has been more resilient than many people expected. Healthy household balance sheets, combined with strong labor markets and growing corporate profits, put Link here challenges from inflation and central bank tightening. The longer runway to growth frustrated a vocal chorus of economic naysayers as they searched for evidence to prove the US was in a recession. The bad news bears of 2022 might eventually be right, but if so, they were also early.
This month, we share how our views are evolving, given what is likely to be a US economy in transition over the next several quarters. Tailwinds to growth are fading. Headline inflation may have peaked, but it’s sticky, and the Fed will “keep at it” to rein in prices. The next few quarters should reveal slowing demand and rising unemployment as we start to reach the end of the runway for this cycle. Recession risks in the US and global economies should not be underestimated. Volatility is elevated as conditions deteriorate, and bear markets in recessions historically last longer. For experienced investors with patient capital, market dislocations arrive freighted with opportunities to put money to work.
A Longer Half-Life To Inflation
If the first half of 2022 were a recession in the US, as many claimed, it will no doubt go down as one of the strongest in history. Despite two consecutive quarters of negative GDP growth—the layman’s definition of a recession—2.7 million new jobs was created, the labor force participation rate improved, continuing jobless claims fell by 20% and corporate profits surged to a record high. I doubt that the National Bureau of Economic Research (NBER) will deem it a real economic contraction. They use a broader set of criteria than GDP alone to determine the official start and end dates for a recession. In many respects, the economy strengthened even as headline GDP figures slowed.
More challenging conditions abroad It’s my view that Europe will see a recession begin as early as the fourth quarter, and the UK is likely already entering a recession. China’s growth also remains challenging, while the strong dollar is pressuring growth nearly everywhere else. The share of sovereign yield curves that are inverted around the world is the highest since the Global Financial Crisis, based on 10-year to 2-year sovereign spreads.1 Spread for most of the major credit default swap indices has also widened significantly since the start of the year.2 Clearly, headwinds are mounting, and they are reflected in falling growth forecasts and rising estimates of recession probabilities for the US, the UK, and the Eurozone (see Figure 1).
Figure 1: Median Consensus Estimate of Recession Probability in the Next 12 Months3
(YoY%)
Headline inflation likely peaked in the US, but its sticky Inflation’s persistence has been another surprise for many observers. However, several encouraging signs from recent US CPI reports suggest that July marked the peak for headline inflation. We can now look past the volatile categories that hit fast and are rolling off quickly, such as energy. Even food, which rolled through more slowly and will take some time to decelerate, is a volatile category that we can assume will swing in the other direction eventually. There’s also observable deceleration in price growth in certain stickier categories. For example, we’ve likely seen the cycle peaks in home price appreciation and rent growth, which is still high but moderating.
Shelter prices hold a big key In the US, shelter inflation—which, like wages, tends to be quite sticky—may not drift down as rapidly as market prices. Shelter CPI lagged the market on the way up, and it very well might do so on the way down. Housing remains structurally undersupplied for the medium and long term, and the pipeline for new home construction is dry. Rental housing markets are equally tight, with historically high occupancy levels. Simply put, the US needs more single and multifamily housing units, and until we get them, demand seems likely to remain higher than the supply.
This imbalance is important because shelter comprises around one-third of the overall CPI basket, and more than 40% of core CPI, which continues to accelerate. With this backdrop, the focus for investors is how quickly inflation falls and what the run rate will be. Here is where they must consider how continued labor market tightness may slow the decline.
Figure 2: Average of G7 Countries’ Short-Term Interest Rates7
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