Inflation and Interest Rates Set the Mood
As the fourth quarter begins, the mood is gloomy. The US Federal Reserve has hiked interest rates sharply and is committed to an aggressive policy stance. There is no “painless way” to rein in high inflation, said Fed Chair Jerome Powell on September 21, as the Fed raised its benchmark policy rate by 0.75 percentage point, taking the federal funds rate target to between 3% and 3.25%. Powell’s statement was seen as an acknowledgement that the US economy is in for a hard landing—and possibly recession.
In Europe, the Bank of England and the ECB also face a tricky balancing act, complicated by an impending energy crunch. Soaring natural gas prices ahead of winter threaten potential fuel rationing because of the loss of supply from Russia, as the war in Ukraine grinds on. In the UK, the new chancellor of the Exchequer Kwasi Kwarteng unveiled a mini-budget including massive tax cuts and fiscal easing measures at a time when inflation exceeds 10%. The moves rattled investor confidence, prompted dramatic declines in the British pound and raise the risks of destabilizing the economy. Fears are rising that the eurozone may be on the brink of recession as well.
The dynamics are different in Asia. Japan may be one of the world’s only developed countries that would welcome higher inflation, and its central bank is keeping rates at very low levels. China is also on a different course, as policymakers are loosening conditions to support an economy weighed down by a COVID crackdown earlier this year and a faltering property market. Economic growth data still look weak.
Will the US or global economy slip into recession? When will inflation ease and where will it settle? How high will interest rates go—and for how long? What about escalating geopolitical risk, from the effects of the war in Ukraine to China-Taiwan tensions?
Nobody knows the answers. Yet for most of this year, equity markets have violently traded on this unholy trinity of rising inflation, rate hikes and growth fears. To be sure, inflation and growth impact company cash flows and earnings, and interest rates play a key role in determining equity valuations. But when macro trends are such a huge driver of market movements, it tends to cloud investors’ vision of company-specific developments that ultimately determine future equity returns.
How Can Investors Gain an Edge?
With so much uncertainty, it’s almost impossible to develop high conviction in a single economic scenario. Yet by studying company fundamentals—where our analysts have skill, knowledge and experience—we can gain a better understanding of how businesses will fare under a range of likely outcomes. This may not insulate holdings from volatility. But it can position portfolios for long-term success by pinpointing companies that are well positioned—or strategically adjusting—to evolving business conditions.
From a bird’s eye view, the earnings landscape looked eerily complacent at the start of the third quarter. Sell-side earnings estimates had generally not come down, suggesting that market participants were not yet fully anticipating the impact of the economic storm. We believe this is unsustainable.
There will certainly be more warnings to come as the third-quarter earnings season begins in October. Investors must comb through the company reports with a magnifying glass and step up engagement efforts with management to identify potential casualties—and surprising opportunities.
Asking the Right Questions: From Pricing Power to Margin Pressure
Pricing power will continue to be a key differentiator in an inflationary world. But identifying quality companies with pricing power requires deep business expertise. For example, one of our investment teams engaged with food producers that have US and UK brands. To assess their ability to increase prices, we study their brand power in each market and ask whether premium products are vulnerable in a tougher economy. Even if they can raise some prices, will it be enough to cover cost inflation and/or lead to a reduction in demand? Answering questions like these hundreds of times over—across industries, companies and countries—is key to determining whether a stock will succumb to current pressures or turn out to be a strong long-term investment.
It’s also important to pinpoint the source of pressure on a business—a tough task when companies are being pounded by multiple economic forces. Consider supply chain bottlenecks. In the auto industry, it’s unclear whether weak sales volumes reflect supply chain snags or deteriorating demand. Supply chain issues are more likely to be resolved sooner. Investors must investigate how industry dynamics are unfolding on a company-by-company basis.
Issues like these will determine whether companies can maintain profit margins to support earnings growth. This warrants a closer look at myriad inputs from commodity costs to currency moves, as the sharp appreciation of the US dollar this year will have diverse effects on companies (Display). Projecting earnings and cash flows is very challenging in such an uncertain environment. But as valuations fall sharply in parts of the market, we can begin to develop conviction by asking whether a range of earnings outcomes are priced into the stock or not.
