Hot Stuff

MON 04 APR 2022

The recent macro news flow has many parallels with the 1970s. As a result, I cannot seem to get the immortal Donna Summer out of my head. The irony of the way price responded to news on Friday following another very strong US labour market report was for front end yields to surge and the 2s-10s yield curve to invert. As we noted last week, yield curve inversion has become the focus of a single story (front page news). Nonetheless, from our perch it would be foolish to ignore the signal from the bond market. The odds of the Federal Reserve to achieve a soft landing are not good.

For equity markets, another important question is the implication of the hot labour market on profit margins and earnings. As Came Crise noted, perhaps the clearest measure of [current] labour market strength is the ratio of job openings to unemployment, which is now almost 1.9 million following the latest payroll release. Wages also remain white hot. Aggregate annual wage and salary growth in the personal income data show year on year wage gains of 11.5% which is close to the highest observation since 1981.

While most analysts are, quite rightly, focussed on (still) constrained supply, the surge in nominal demand had also clearly had an impact on prices. However, it is important to note that demand has probably started to fade consistent with the sharp slowdown in new orders relative to inventory (chart 1). Indeed, US growth in Q1 was flat excluding inventory. The big picture point is that production and growth is likely to slow sharply over the next quarter. A few of my astute bottom-up friends have highlighted this issue over the past few weeks in key industries.

That sets up a very interesting Q1 reporting (and forward guidance) season over the next few weeks. The new orders to inventory ratio lead future production by one quarter and earnings per share or profits (chart 2). In addition to the likely slowdown in final demand, the big picture question is whether businesses can absorb rising labour costs without hitting margins. While consumer (final) prices have been rising more than wages, other input costs (commodities, overheads etc) have also clearly become a challenge for profits. Moreover, profit margins are starting from a record high level based on either the S&P500 or the corporate share of GDP. From an individual company perspective, pricing power has never been more important for stock selection.

The battle between capital and labour or the profit versus wage share of GDP has long been an important secular factor for equity returns. Over most of the past four decades it has trended in favour of capital (shareholders). While the structure of the labour market is very different from the 1970s (in terms of unionisation) the risk of a shift back has probably never been greater. The related challenge for markets is that current inflation pressure has clearly shifted beliefs higher on future short term interest rates, ironically at a time when growth has started to slow. However, the Fed is likely to hike rates and withdraw liquidity (reduce the balance sheet) until inflation slows or something breaks. For our portfolio, this suggests maintaining cash for optionality and quality (high free cash flow, low balance sheet leverage and inexpensive valuation). In the 1970s, companies that could grow dividends were an effective hedge against inflation.