Looking beyond inflation
07 September 2022
The market is currently gyrating between inflation and potential economic recession, which muddle the visibility of the Fed’s future policy. But the time lag between how these economic variables are likely to evolve may be the key to asses future market action.
The market rallied close to 25% from the June FOMC meeting (and its 75bps hike) until mid-August. This rally can be explained by the market participants reassessing (too quickly) the path of the Fed’s interest rate policies: market expectations for 2023 went from two hikes to two cuts. Indeed, the market considered the inflation headwind to be a story of the past and started to focus exclusively on the growth slowdown, anticipating the Fed to ease by next year.
However, the Fed never changed its communication and reaffirmed, in particular during the Jackson Hole conference, that it will not become less restrictive until they are highly confident inflation has been beaten down.
In other words, they will continue to tighten even if it causes a recession. Therefore, markets gyrated back to focus solely on inflation.
Impact on our Investment Case
A clear downtrend in inflation, before a potential recession, which might come only next year, will allow the Fed to look beyond inflation in shaping a less restrictive monetary policy, benefiting risky assets.
While the odds of an actual recession are increasing, we continue to believe that inflation will soften, especially during this fourth quarter, mainly due to base effects and other exogenous factors such as high inventories or the collapse in shipping rates.
Below we quickly go over inflation, the housing market, and the job market to help frame a view for the rest of the year. We finally provide an update on our investment themes.
Irrespective of when the recession will start, whether it is next week or next year, the key to the market performance for the rest of the year remains inflation; more precisely, how fast it will drop before the actual recession kicks in.
The Fed’s only focus is whether inflation prints will be going down significantly. In fact, this can happen without an Armageddon-style recession that many predict. As explained in a previous note, base effects and goods components will mechanically drive down inflation. As for the sticky parts (which are the current trouble in this market) such as real estate, as we shall see, the rise of shelter inflation should also soften.
If inflation indeed made its high this summer and recession only hits next year, then the current market turbulences remain a buying opportunity.
The base effect can become massive in the last quarter of 2022. Here are a few examples that show that we are already in deflation for many of the components that caused previous quarters’ high inflation.
First, a lot has been written about the skyrocketing cost of freights. Indeed, the FBX Global Container Index rose from about $1’500 before the Covid to more than $11’000 during September 2021. At the beginning of September 2022, the FBX Index was below $5’000, or a drop of about 60% YoY. Similarly, the Baltic Dry Index, which also measures the cost of shipping goods, is down more than 75% YoY. Thus, in the coming months, the reduction in shipping costs is likely to be reflected in prices.
Besides, among other CPI components, used cars, which account for 4% of the CPI and that rose to 45% YoY on June 21, are now (only) growing at 6.6%. The Manheim Used Vehicle Value Index is down 10% YTD and will probably be down YoY by October 2022.
Airfares, which are up 27.7% YoY, are down 9.6% MoM. In fact, many components of the CPI are still printing positive YoY changes but are already significantly below their recent highs. The Commodities less Food and Energy Commodities component is rising at 6.9% YoY, down from 12.4% YoY in February 2022.
It is also important to note that even the last CPI, as a global indicator, was slightly down MoM (-0.02%).
Regarding ISM Price paid, which is a leading indicator of inflation, has quickly dropped, going from 87.1 in March 2022 to 52.5 in August 2022.
Thus, we continue to believe that in the short term, inflation can go down, even more than the economists’ consensus expects.
As shown, many indicators suggest inflation is bound to cool down. Some questions remain about the stickier components of inflation. But we believe that also the housing market will slow down its rise, albeit with its natural lag. As we detail here below, real estate indicators are still pushing for some sort of housing crisis which in effect will put housing, the main inflation component and sticky contributor, in deflation.
The main component that keeps rising and is expected to prevent inflation from quickly coming down is shelter inflation. In other words, broad real estate continues to go up on a YoY basis. However, many indicators are suggesting the trend is already reversing.
But first, let us observe that while many consider shelter inflation to be sticky, i.e., slow to change, we notice that historically, it has not always been the case.
For example, the Shelter component of the CPI was 21% in June 1980 and dropped to 9.2% by June 1981, and was at 1% in June 1983. Similarly, it fell by more than 50% in 2002 and even was briefly negative in 2010.
Thus, while it is a component that is much less volatile than food or energy, there are historical instances when it showed swift movements.
More specifically, on the current housing market, we believe that real estate inflation could end during the first semester of 2023.
Indeed, let us first observe that the monthly supply of new houses is close to historical highs. It represents, in months, how long the current supply of new houses would last given the current sales rates.
Similarly, the number of new one-family houses sold has been falling by more than 50% over the past 2 years and is now back to 2015 levels.
These indicators already suggest some sort of cooling in the housing market.
According to RedFin, 21% of homes for sale had a price drop in July, the highest level since 2019.
We also start to see a change in trend for the S&P/Case-Shiller US National Home Price Index, which has stopped its increase.
One of the leading causes for the cooling of an over-heated housing market is the rapid rise in mortgage rates. For example, the 30-year fixed rate mortgage almost doubled within one year to reach more than 5.5%.
Thus, housing prices are plateauing, and these various indicators suggest a cooling is about to come, especially with the Fed keeping its tightening stance.
Should the housing market even only stop increasing, its contribution to inflation will be muted. Currently, with shelters contributing more than 20% of CPI and 40% of core CPI, a muted shelter component will greatly help inflation go back to its historical average.
Growth and the job market
As mentioned, various economic indicators are all pointing to a continuing slowdown of the economy. This started more than 18 months ago, and we still do not see any improvement in these indicators. As we have written, we do not believe that the actual recession is already here, even with the two consecutive quarters of negative growth. Yet the equity market already prices a PMI below 50.
The job market is historically the last component among the four (income, production, consumption, employment) to turn south and usually confirms the recession. As shown below, every recession starts with the unemployment rate going up.
The job market appears to be healthy, but looking under the hood, we observe that it started to shift a few months ago. For example, Initial Jobless Claims started to rise in April 2022.
There are various surveys for assessing the state of the job markets. A first one surveys businesses (the Establishment survey). The main number produced by this survey is the Non-Farm Payroll or how many new payrolls there are on a given month. A second one surveys households and the main number that is produced is the unemployment rate.
Obviously, there are differences between the two. But a thought-provoking one is that multiple job holders are counted only once in the Household Survey but multiple times in the Establishment Survey. Thus, looking at the Household Survey, we observe that in April and June 2022, the MoM change in the number of employed people went negative, but this did not show up in the NFP data that kept showing positive numbers. In fact, this difference might be explained by the multiple jobholders that increased by 14% YoY to reach about 5% of the total employed.
Moreover, government jobs increased by 4.7% YoY, and private industry jobs increased by 4.3% YoY. In a robust economy, we would have expected more hiring from the private sector rather than from the public one.
Lastly, we observe that the Job Openings is also softening.
Thus, while we clearly observe that we are not at recessionary levels, many indicators are suggesting an initial deterioration in the job market, but the negative effects may only show in the next 6 to 9 months.
In other words, while the job market does not look as bright as the Fed or the media portrays it, we believe that there is still time until the recession actually kicks in.
Besides, the recent decline in energy prices in the U.S. relieves consumers’ purchasing power. This will allow consumers, the backbone of U.S. GDP, not to stop their spending drastically. This should at least give more time before a recession hits.
In the next section, we provide an update on the outlook of our investment themes. The content is adapted from our webinar held on 30 August 2022.
Artificial Intelligence & Robotics
The past few months have been quite challenging, especially for the Semiconductors and Data Infrastructure segments, which have been hammered by macroeconomic concerns. At the same time, these sectors have become so massive that they cannot escape some slowdown.
This slowdown is already materializing in the consumer segment, leading players like Intel to release weak earnings. However, fundamentals in the B2B-oriented segments, such as datacenters and 5G infrastructure, remain solid and comfort our view of an unstoppable democratization of AI applications in the coming years. The first applications are already here, yet the underlying infrastructure is far from maturity, and both will massively grow in symbiosis – that is, if China does not invade Taiwan, which would be an abysmal catastrophe for the semiconductors industry.
Some segments may also actually benefit from an economic downturn: Robotic Process Automation, which enables replacing people used in low added-value and repetitive administrative tasks, is one of them. The same might apply to some segments of Robotics, such as automated logistics, although the upfront cost may be harder to bear for businesses already under pressure.
Finally, a revolution is (at last!) around the corner, namely autonomous driving. After years of delays, the first truly driverless robotaxi services are now generating revenues in China, where the first high-volume level-4 vehicle will be commercialized in 2023 by Baidu .
All in all, despite a hit from consumer-related macroeconomic factors, which will inevitably impact at some point also some non-consumer areas, fundamentals remain solid for B2B-oriented businesses. Advanced AI applications are progressively coming of age, yet still need the roll-out of a solid infrastructure to support them, meaning strong opportunities all across the chain.
Not a single index is in the green, the sector has been sent back to customer service. After analysis, the diagnostic is bad but not terminal. The cocktail of hard-to-come-by medical staff, supply-chain block in China, inflation unbalancing the benefit/cost ratio, and Covid-19 policies limiting access to hospitals was explosive.
Backlog was growing while elective procedures were reduced. Now that elective procedures are almost back to pre-pandemic levels, the backlog can be addressed and provide a much-needed catch-up boost, e.g., more than 60mn Americans are waiting to be screened for colorectal cancer.
Fears of recession and a dip in profits (led by fewer admissions and inflation) are driving hospitals to be more selective about capital expenditure with only some pockets of growth surging, such as better care management and medical equipment for lucrative elective procedures.
The Cures 2.0 Act is the main focus, as it includes several provisions to expand patients’ access to medical innovation:
- Breakthrough medical devices will be automatically reimbursed following FDA approval. Reimbursement is paramount in the drug industry in general, but it is THE criterion specifically for MedTech innovation. This is the one true competitive advantages as it could take years for a better technical solution without reimbursement to beat a reimbursed one.
- Expanded access and coverage of telemedicine services.
- Regulation for AI-based medical devices will be designed to accelerate the development and advancement of these solutions.
- Real-world data collected will be valid for clinical trials.
- Increased coverage and access to genetic screening.
On the product front, the first half of the year has seen several product launches with significant technological advancements; i.e., the automated artificial pancreas, implantable devices with a longer-lasting battery, etc. The next generation continuous glucose monitoring (CGM) system, smarter and 40% smaller, is also coming.
The M&A activity was 85% lower in 1H22 than in 1H21, but we don’t exclude a strong comeback in 2H22. Large tech and healthcare players have been eyeing care management solutions and telemedicine services as a way to lower costs and diversify their revenues (i.e., recent acquisitions of 1Life Healthcare, and Signify Health).
Finally, most actors don't foresee a future supply chain block comparable to 2021 or early 2022. Medtronic, during the announcement of its 1Q23 earnings results, pointed out that the supply chain was significantly improving.
To sum it all up: innovation is coming and will be rewarded, as it is all about boosting healthcare efficiencies and patient outcomes.
Was the last quarter the end of the bad trip?
Biotech indexes have been in free fall since February 2021 or what we could call a “very bad trip”. The sector bounced on June 15th on the narrative that the worst of the inflation should be behind us. But the sector is left scarred after its biggest drawdown ever (XBI down >60%), with 2/3 of biotech trading below the $100m market cap level and the broadest series of layoffs.
Despite the depressed sentiment, biotech companies trailblazed the field with 3 landmark events.
- Entry in the clinics of an engineered version of CRISPR (gene editing tool). Spearheaded in the clinics by Verve therapeutics, the event is a major milestone on the gene therapy roadmap.
- The impressive results in cell therapy by Arcellx and NKarta, in a subset of cell therapy with no approved drug yet. More details in our note on the topic.
- Entry of AI-discovered drugs in the clinics. Schrödinger got the green light from the FDA to start clinical trials for its first asset, and Exscientia will publish Phase 1 data.
There are reasons to be excited about the fundamentals, but will the market follow?
Interestingly the M&A activity, a major driver in the sector, has picked up since June, both on the rumors side (with the putative $40bn mega-buyout of Seagen by Merck or with real deals in the $2-$10bn bracket, like Pfizer’s buy-out of Global Blood Therapeutics.
To provide some perspective, M&A activity plummeted from the highest in a decade with 600 deals in 2Q20 to the lowest in a decade at 300 deals during 2Q22. In the meantime, the top 20 pharma amassed $500bn in cash, enough to buy the whole SMID sector with ~20% premium.
With 1/3 of all the listed biotech that IPOed between 2020 and 2022, the business development teams of big pharmas is flooded with acquisition candidates. Unfortunately, they cannot afford the buyers’ choice paralysis for too long as the most painful period of patent losses in over 30 years will be 2025-2030.
Additionally, Medicare is gearing up to negotiate drug prices starting in 2026 with discounts expected to be around 40% on the top 10 blockbusters. Medicare is 30% of the prescription drug revenue in the U.S., so it is a big deal for the pharmas. As we explained, the way out is to have new drugs commanding high prices and ready to be launched.
Luckily, the Biotech pipeline is full of life-changing, high-priced therapies. The most notable example is Bluebird Bio’s single blood disorder injection, priced at $2.8mn. As a point of comparison, it would cost a U.S. patient ~$6.4mn for a lifetime of blood transfusions, therefore Bluebird solution is even cost-effective.
On the drug development front, patients with NASH (the most devastating liver disease without treatment where fat builds up in the liver causing malfunction, cirrhosis, and cancer) will closely follow the Q3/Q4 clinical results of Intercept and Madrigal’s drugs. Blockbusters may be in the making.
In a nutshell, catalysts and money are piling up for biotech. Of course, uncertainty around clinic trials remains, but the hope for patients, built up in the companies’ pipeline, has no price tag.
The latest earning season confirmed the switch of focus to profitability noticed this year. Increasing client engagement has become essential. Fintech companies are looking to captivate their users by cross-selling different products.
This healthy transition finds its roots in the current macroeconomic environment. The leading fintech companies have put on pause their model of growth-at-all-costs. The acquisition cost of new customers is on the rise; younger fintech companies are delaying expansion plans for new markets or products. They must tread cautiously with their balance sheet.
A slowdown in investment does not mean that innovation is dead. Fintech remains a cash-rich industry that benefitted from easy money for years. The ongoing developments in blockchain are a good example of this trend, starting with the Ethereum Merge. This major upgrade of the smart contract platform changes the tokenomics of Ethereum and has the potential to impact the entire blockchain ecosystem – developers, users, investors, etc.
Covid-19 significantly changed the way people pay, invest, save, borrow or insure. These new behaviors are here to stay; younger generations will not bank like their parents.
In parallel, as inflation is pressuring margins, the use of technology to execute financial processes and operations will be more relevant than ever. This is particularly true for smaller companies that have just started their automation process.
The macroeconomic environment has not favored fintech, which is by definition more cyclical given its higher exposure to consumers. But the disruption of the multi-trillion financial industry is far to be over. Fintech challengers will keep gaining market share over incumbents.
Despite the macro uncertainties, the global volume of payments has not decreased yet. Using data from the main card networks and PayPal, the purchase volume processed digitally should reach an all-time record in 2022. The annual growth in the digital payment volume is expected to be close to ~12.7% - slightly above the long-term average of 11.7%.
However, payment companies stocks have been strongly impacted by macro uncertainties, on top of the normalization of revenue growth after the Covid-19 boost. Sentiment remains low, as surveys of consumers keep impacting the industry, a gauge of the future economic activity and payment volume. The University of Michigan Consumer Sentiment Index reaches levels that have not been seen since the Great Financial Crisis.
Early signs of a potential slowdown in payment volumes in the U.S. are appearing. The below graph shows that middle class and richer individuals have consumed less as of lately.
How much of a slowdown in the volume is already priced in, given the multiple compression the industry has experienced in the past 12 months? Nobody knows. But we notice that at the current valuation levels, industry players are keen to acquire their competitors. A new consolidation wave has started and is likely to accelerate as incumbents struggle to generate organic growth. As an illustration, we can note the recent acquisition of Evo Payments by Global Payments (new market), or the acquisition of Accrualife by Fleetcor (new product).
Besides valuations, another major catalyst also explains a renewed M&A activity. The payment infrastructure is on the verge of significant changes. New regulations targeting credit card networks could reshuffle the cards and weaken the quasi-duopoly of Visa and Mastercard in the United States. Moreover, the instant payment system prepared by the Fed is scheduled for next year. The penetration of account-to-account payments will accelerate. A deep-dive article highlighting the likely winners and losers of these changes is being prepared.
To summarize, valuations reflect the low sentiment of consumers. A new consolidation wave has started, and major changes in the U.S. payment infrastructure are about to happen.
Security & Space
The major recent event has of course been the invasion of Ukraine by Russia, which generated intense focus on the defense segment and greatly renewed the interest in general security. Although we do not invest in defense pure-players for straightforward ESG reasons, this conflict still had ripple effects on our themes on two levels: the increase in cyberattacks and the crucial role taken by satellite imagery.
Another important event, the tightening monetary policy, also substantially impacted younger companies with a high-growth profile, typically our investment sweet-spot both in our cybersecurity and space exposures. However, the stress-test we ran last May did not detect any major liquidity problem for our portfolio holdings.
Turning our eyes to the future, the likely continuous increase in cyberattacks will act as a tailwind for the cybersecurity sector. Given the crucial importance the sector has taken, fueled by regulation and engaged in a technological transition towards the Zero-Trust framework, we do not expect macro to have an overwhelming impact, and the earnings season tended to comfort this view, with corporates suggesting that budgets are more than holding up.
We also expect a rebound of well-capitalized players in the space segment: after the collapse of the space SPAC bubble, survivors are progressively maturing their business models and infrastructure and will soon start to generate revenues. In addition, we expect the sector to benefit from headline newsflow: first with NASA initiating its return to the Moon, and second, by smartphones becoming connected to satellite networks, one of the most important space-innovations for daily life since the inception of commercial GPS.
All in all, while the sector has indeed suffered, growth drivers remain significant and will benefit from major catalysts in the coming months.
The first half of the year was challenging for the energy sector, with high commodity prices, supply chain bottlenecks, and inflationary pressures. The world is undergoing a big energy crisis, and energy security is being brought back to the top of government priority lists. The Russia-Ukraine conflict is threatening Europe’s energy systems as about 40% of the E.U.’s gas supply came from Russia (prior to the war).
In response to the current challenges, governments are unveiling new plans such as the €210bn REPowerEU whose goal is to reduce Europe’s dependence on Russian fossil fuels. It includes a set of measures intended to improve energy efficiency, diversify fuel supply, and boost renewables (which are critical to improving energy security). Last month, Biden signed the historical Inflation Reduction Act into law. This new law provides $369bn to climate-related projects and to the cleantech industry, representing U.S.’s most aggressive climate action ever.
Investments in clean energy are breaking new records, reaching $226bn in the first half of the year (representing a 63% YoY growth). In the near term, we expect high fossil fuel prices and energy security concerns to act as a tailwind for renewables and especially for the solar photovoltaic industry which benefits from short construction cycles, competitive prices, and supportive policies.
Below we detail portfolio metrics for each of our themes. Investors can see how we are positioned in terms of leverage risk, valuation levels, and growth.
Investors are concerned that inflation will stay high for a long time, preventing the Fed from softening its tightening policy. Therefore the equity market is weakening. Moreover, they believe an actual recession can start soon. Our base case is that inflation is likely to fall faster than the market expects, and should we endure a recession, the latter may begin only next year, giving the Fed more flexibility in shaping its monetary policy.
Adding to such a macroeconomic scenario, most if not all our themes have significant supporting structural trends and after having suffered a harsh 1H22, are ripe with catalysts for a better second half of the year, as we have long been anticipating.
Companies mentioned in this article
Merck (MRK); 1Life Healthcare (ONEM); Accrualife (Not listed); Arcellx (ACLX); Baidu (9888); Bluebird Bio (BLUE); Evo Payments (EVOP); Exscientia (Not listed); Fleetcor (FLT); Global Blood Therapeutics (Not listed); Global Payments (GPN); Intel (INTC); Intercept (ICPT); Madrigal (MDGL); Mastercard (MA); Medtronic (MDT); NKarta (NKTX); PayPal (PYPL); Pfizer (PFE); Schrödinger (SDGR); Seagen (SGEN); Signify Health (SGFY); Verve therapeutics (VERV); Visa (V)
- Bank of America
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