Monday digest
Posted 24 January 2022
Overview: Markets on a bumpy road to somewhere
Global equity markets have been in a downward trend since the end of 2021, led by US stocks. America’s mega-cap tech companies that were so loved throughout the pandemic have taken the biggest hit – with the tech-heavy Nasdaq falling nearly 10% in January. The change of fortunes was made abundantly clear on Friday morning, after stock market darling Netflix plummeted 20% in pre-market trading following a warning on subscriber growth. UK equities seemed immune to the downturn in the first two weeks of the year, but even that changed last week as the FTSE 100 joined the broader fall. The global economy has been similarly tumultuous. There are early indications that the intense supply-side pressures we saw last year are easing. Input costs no longer spiking and supply chains freeing up, but that shows little sign yet of feeding through into inflation data. Prices are still spiking across most major economies, and consumers face a daunting shock to their real disposable incomes in the next few months. Meanwhile, growth is slowing, and central banks are removing their emergency support.
On a geopolitical scale, all eyes are on Russian-Ukrainian tensions with its repercussions on the relationship with NATO members. The threat of destabilising conflict is significant, and Russian financial markets have reacted negatively. Government bond spreads have widened, and the stock market underperformed its Western peers. Global markets seem more pre-occupied with their own troubles though, as the big pandemic winners adjust their earnings outlook to a world without stay-at-home policies, and most importantly, the tightening stance from the US Federal Reserve (Fed).
We suspect Western economies are living through the last bout of COVID-induced distortions. If so, the coming quarters will reveal the genuine underlying pace of growth, and hence companies’ long-term earnings potential. The transition phase will bring both pros and cons for markets. On the plus side, fewer virus restrictions will be a boon for those industries that have struggled in the last two years, particularly services, while input cost pressures should subside. On the other hand, real disposable incomes will be hit with higher prices, while monetary and fiscal tightening will add to the squeeze on businesses and consumers. As the growth cycle matures, markets will adjust toward higher real interest rates, not just in the US but across most major economies. This is all part of the road back to normal, but after so long on emergency support, there will inevitably be bumps along the way.
Earnings reports so far: no surprises, but little to write home about
Reporting of corporate earnings for the last quarter of 2021 is in its early days, but the results so far are decidedly mixed, if in line with expectations – no major surprises on earnings growth, sales, or forward guidance. In the US, much of the action has been driven by banks, which have recorded some decent but underwhelming results. JPMorgan and Goldman Sachs reported some higher-than-expected costs, but these do not appear to be industry-wide trends. Overall growth is expected to be healthy, but the outlook for the next few quarters shows a marked slowdown from the stellar figures in the first half of 2021.
Across all sectors, the picture emerging is one of deceleration – as firms come away from the giddy COVID recovery last year. That is not necessarily a worry for markets or the economy. A year of lockdowns saw the biggest drop in global activity recorded, and the recovery from those depths returned equally large growth figures. But most major economies are now at or above their pre-pandemic GDP levels – so further growth will inevitably look much more ordinary. The big question now is what the world economy’s cruising speed will be. Central banks have grappled with this conundrum for the better part of two years. According to its latest communications, the Fed is planning at least three interest rate hikes this year, along with a sizable reduction in its balance sheet later in the year. For now, investors and market watchers are undecided on whether this is too harsh an approach.
The bulls argue markets have enough resilience to withstand monetary tightening – especially if Omicron proves the natural end to the COVID emergency. JPMorgan takes this view, predicting not only that Q4 earnings estimates are too low, but that 2022 will surprise to the upside. The bears point to the risks that Fed tightening, and slower short-term growth, could pose. In 2018, it hiked rates four times and reduced its total assets amid positive US and global growth. That cocktail did not immediately harm capital markets, but the drying up of liquidity created unease – and the ensuing volatility caused markets to swing downwards in the second half of the year. The bears might also point out that the underlying growth picture now is arguably worse now than it was then.
Our best guess is somewhere in the middle of the optimistic and pessimistic cases. For all its tough talk, we expect the Fed will adapt should the economic outlook worsen. Officials are serious about fighting inflation, but will be ‘smart’ enough to avoid a hard landing. With growth slowing and the Fed (for now) tightening, we are likely to see more volatility in earnings, equity values and, indeed, the real economy. However, it is still too early to call this the end of the cycle, and we expect sustained growth on the horizon.
The trouble with ‘just-in-case’ supply chains
Most people agree that soaring prices over the past 18 months have come from varied and unique supply-side issues across the world (even if against a backdrop of growing demand) and history tells us that these disruptions are usually short-lived. That said, the scale and longevity of these disruptions have made them a significant and unexpected problem for policymakers. Supply hold-ups are nothing new; shutdowns, warehouse fires, and regional shortages have always been a factor in the delicate global economy. But never have these problems been so ubiquitous since the start of post-war globalisation. A prolonged period of difficulty like this naturally leads to some questioning existing models, for both politicians and businesses.
Since at least the 1980s, rapid globalisation has driven suppliers toward a ‘just-in-time’ model of delivery. This relies on each part of the supply chain running like clockwork – which brings risk if individual links break, but those risks are mitigated by access to a vast global market. However, persistent global supply pressures are a major risk to that model. The longer these pressures continue, the more people will question whether we are better off moving to a ‘just-in-case’ model – where inventories are held as back-up. A longer-term solution firms would be to move to simpler supply chains altogether, either through local sourcing (at a possibly higher price) or vertical integration. These can be more costly, which in the past was enough to discourage businesses from taking a just-in-case approach. But if it allows firms to take frustrated customers from their just-in-time competitors, the cost would be more than worth it. This is borne out by stock markets: since March 2020, companies positively exposed to supply chain management have outperformed those negatively exposed.
If enough companies switched to a just-in-case model, it would lead to a significant structural change for global markets, and this will create a drag on earnings if companies run higher inventories over the medium or long-term. This would reduce asset turnover and in turn lower companies’ return on equity. As mentioned, there could be strong incentives to bear this higher cost if it means increasing market share. The result, however, is a market structure that returns less than investors have come to expect. Given the exceptionally high profit margins and equity valuations (by historical standards) that investors have seen in recent years, this could take some getting used to. Any significant change in the supply structure will be hard to sustain without policy changes. Input costs and supply disruptions are already slowing down, and despite their longevity it is hard to argue they will be a permanent feature of the global economy. Corporates are likely to be mindful of a well-diversified supply chain, and (at least to a certain degree) just-in-time models will persist in the mix – unless governments step in to discourage it.