Mid-year Review 2022 - Macro: Inflation to the sky?
30 June 2022
Let's get back to earth. Core inflation will start its landing this year, bringing less restrictive and more flexible monetary policies.
Investors, politicians, and central bankers fear stagflation, which we identified as one of the main risks for this year. But the nightmare is run-away inflation leading to hyperinflation. While we believe it will not happen, central bankers cannot take that risk, even at the expense of a recession, which we are likely experiencing already now.
Headline inflation and other inflation-related data will be highly scrutinized during the coming months. A clear downtrend in these measures will likely signal the beginning of a new economic cycle, for which we are well-positioned.
Inflation to the sky?
As we wrote, economic growth started its slowdown more than a year ago. Several in-house and external indicators continue to suggest a deceleration is there, but do not yet confirm the recession. However, our economic base case for the months to come is a recession.
Indeed, given persisting inflation, the Fed switched its post-Covid ultra-accommodative stance by mid-4Q 21 and took an increasingly hawkish attitude by raising its projected Fed Fund Rates (FFR) for December 2022, severely affecting the stock and the bond market. The latter posted its worst start of the year ever. For example, the TLT ETF drawdown is 40%, taking it back to 2009 levels. We warned that bonds were not safe anymore. Equities, particularly small and mid-cap growth stocks, also massively suffered, going back to their pre-Covid level, mainly in anticipation of Fed restrictive policies. For example, the Russell 2000 Growth erased its entire Covid-19 rally. However, the valuation levels of this small-cap growth index are much better now, with a forward PE of 30 vs. 45 in January 2020. Similarly, the S&P 500 price/earnings-to-growth ratio is at 1.2 vs. 1.8 in January 2020.
At the beginning of the year, following the January FOMC meeting, we expected the Fed to set a less hawkish tone sooner, given the slowdown in growth and the likely turning point of inflation by the second semester. The Russia-Ukraine war proved us wrong. It has postponed this outcome and worsened both growth and inflation. Nevertheless, we still believe the second semester will be better than the first, given the likelihood of core inflation softening coupled with the actions taken by the Fed.
The Fed eventually stopped QE and started to increase its target rate by 25bps in March 2022, followed by 50bps in May and 75bps in June, only to catch up with market expectations, which currently project FFR to be between 3.25% and 3.50% by year-end (in line with the Fed's "Summary of Economic Projections"). Moreover, the Fed activated its balance sheet reduction program by about $50bn per month from June until August and about $100bn per month starting in September. As we explained, it mechanically removes liquidity from the financial system, thus reducing the availability of money. Indeed, Quantitative Tightening will force the private sector to step in during Treasury Bonds' issuance.
As we wrote, after the various easing program, the Fed needed to regain credibility. They are on the path to achieving it, as shown by the strong U.S. Dollar, the removal of the Fed put, and the scrutiny of its actions by financial actors.
We are thus facing an economic contraction combined with restrictive monetary policies to fight a high level of inflation that did not yet start its downtrend. During his last FOMC press conference, Jerome Powell said he would like to see positive real interest across the curve because this will bring down inflation. Real interest rates at the front-end are still negative, advocating either further hikes or a sharp drop in inflation expectations. We believe the market underestimates the probability of the latter.
Inflation: The mother of all evils
As inflation is and will be the main story for the coming months, we quickly review our reasoning for affirming that inflation should go down during the second semester of 2022.
There are many measures to assess inflation. For example, Consumer Price Inflation (CPI) is computed by the Bureau of Labor Statistics (BLS) and uses data from household surveys while the Personal Consumption Expenditure (PCE) is computed by the Bureau of Economic Analysis (BEA) and uses data from the GDP report and from suppliers. Also, one typically differentiates between headline and core inflation. The latter measures inflation without the volatile components of food and energy.
The latest data on inflation does not allow us to say that the peak of inflation is already behind us. However, a careful reading of the release suggests that headline CPI is bound to come down, as we shall see. Besides CPI, other inflation hard data are easing. For example, the Core PCE, the Fed’s preferred measure for inflation, is currently trending down (the last print was the lowest of 2022). Moreover, the Producer Price Index (PPI) and the core PPI printed their second lower high in a row, suggesting an easing in cost inflation. In May, the core PPI print was also the weakest of the year.
Additionally, market-based measures of inflation such as breakeven inflation yields did not jump to their March-April highs. The entire curve suggests inflation will return to an acceptable level within the next few years (e.g., 3.8% in 2y, 3.2% in 3y, 2.3% in 5y, and 2.6% in the long run), discounting the structural inflation idea. Only consumers’ inflation expectations are rising.
Trees of inflation do not grow to the sky
We believe inflation will go down. Base effects and the roots of its rise will dampen inflation prints in the next 12 months.
Indeed, the current inflation was mainly due to three consecutive waves: (i) shortage of goods due to Covid lockdowns, followed by (ii) strong demand for goods driven by the reopening and the strong disposable income granted via fiscal measures. Then, at the beginning of this year, as the goods inflation started to ease, (iii) the food and energy prices continued their uptrend because of the Russia-Ukraine conflict, thus impacting headline inflation.
First, base effects are strong, especially when the level of inflation increases rapidly. Inflation is always calculated on a YoY basis, i.e., we compare the current level with the one 12 months before. Mechanically, if the latter is high, then next year's inflation will be lower because it will be calculated on a higher denominator. Below is a chart illustrating this point. We plotted the level of inflation with a 12-month lead against its YoY number. With a higher denominator, we can expect the YoY reading for the next 12 months to at least stop increasing, if not reduce altogether. In the chart, we observe that during periods where the level was increasing (e.g., from Jan-19 until Jan-21), the YoY inflation remained flat or decreased. On the other hand, during periods where the level was flat or declining (e.g., from Jan-21 until Mar-22), the YoY inflation increased. Currently, we observe that the denominator for the year ahead has risen massively, advocating for a sharp slowdown in YoY numbers, due to the base effects.
What is increasing that much?
Besides the mechanics of the base effects, a significant contribution to the current high level of inflation has been caused by goods inflation, identified within the BLS as "commodities less food and energy commodities", whose weight is 21.4% in the CPI.
This is the main component that has been a headwind for high inflation for the past three decades and massively increased post-Covid because of the first two waves mentioned above. We argue that this component will fall back to its behavior, i.e., close to no inflation by default and deflation from time to time. Indeed, competition, automation, and globalization are strong headwinds for goods inflation.
Of the 8.6% YoY of May CPI, we believe that items contributing at least 2.2% would not only stop increasing very soon but could even start decreasing. Thus, contributing to reducing the level of inflation.
Below is a table showing some components of the May CPI and their contributions to the latter.
|Indent Level||Expenditure Category||Contribution||Weight (%)||YoY
|1||All items less food and energy||4.70||78.32||6.0||0.6|
|2||Commodities less food and energy commodities||1.82||21.4||8.5||0.7|
|3||Household furnishings and supplies||0.38||3.97||9.7||0.1|
|3||Transportation commodities less motor fuel||1.20||8.54||14.1||1.4|
Let us consider a few examples to illustrate our thesis. First, with the global easing of the supply chain, the halving in freight prices since September 2021, or with lumber prices back to pre-Covid level, the "household furnishings and supplies" components are likely to go down within the next few months. Regarding "apparel", we shall see that inventories are skyrocketing. Moreover, real retail sales are flat YoY, and the Fed’s actions further destroy demand. Thus, it leads us to think that stores will soon have to sell at a discount to reduce inventories, a strong headwind for apparel inflation. Besides, half of "transportation commodities less motor fuel" is composed of used cars, which according to many indicators (e.g., Manheim used vehicle value index), are decelerating on a YoY basis and even declining on an MoM basis. Lastly, the "transportation services" component includes airline fares which increased by about 40% YoY and contributed 25bps to the overall CPI. Airline fares are volatile, quickly adapt to market conditions, and cannot maintain such increases for an extended period.
Besides, a strong driver for inflation is demand. While the latter was high during the reopening and caused the second wave of inflation, the demand is now basically muted. Indeed, real disposable income dropped massively, below its long-term trend, and retail sales are flat.
"I am full of stuff"
As mentioned and shown on the graph below, inventories are reaching extreme levels.
Given the flat YoY real retail sales, this is a strong headwind for goods inflation. In other words, retailers have 30% of excess inventories, the highest number ever recorded. Many sellers (e.g., Walmart, Target) acknowledged that they would have to sell their stocks at a steep discount.
Thus, higher inventories and sellers’ discounts mechanically put downward pressure on inflation. As shown in the below graph, we observe that as inventories go up, they tend to slow down, and goods inflation comes down after.
As observed, with flat real retail sales, skyrocketing inventories, and a higher cost of money, consumption will get reduced. All ingredients are here to have the reverse effect of the Covid reopening, i.e., low demand and high supply. In other words, an intense and rapid disinflation.
Finally, as explained here, long-term yields are intimately linked to demographics. With the low reproductive rate in the West and China, deflationary forces are much stronger than inflationary ones. Moreover, technology enables cheaper products, and our world is going in that direction. Therefore, while slightly higher than their historical averages, long-term inflation expectations should not rise meaningfully.
Shaky housing. Will it crack?
With QE pushing asset prices up, asset owners benefited from wealth creation. To fight this level of inflation and kill demand, wealth destruction could be one of the goals of the Fed. Since wealth is mainly distributed between the stock market, via the 401(k), and the housing equity, the Fed will not be sad should the stock and the housing market take a severe hit. In fact, the largest group of consumers have much more wealth in real estate than in the stock markets. By May, the financial market had already erased $7tn of wealth. The housing market, being more illiquid, reacts with a lag. As written, house prices increased massively during Covid, and we suggested that rates would rise because of this overheating housing market.
Currently, many housing data are pointing towards a sharp drop in the housing market, contributing to reducing wealth, demand, and consequently inflation. First and foremost is the sharp increase in mortgage rates. The 30-year fixed rate mortgage currently hovers at about 6%; it was below 3% just 18 months ago. Not only is the level the highest since the 2008 crisis, but the YoY change, even in basis point terms, is the highest in the past 40 years. An immediate consequence of this rise is that 18mn households can no longer qualify for a $400k mortgage. It is a sharp reduction in demand. Indeed, the typical buyers with such a mortgage would have their monthly payment increased by 50% YoY.
Besides, the NAHB Housing Market Index, a diffusion index similar to PMI for the housing market, is also sharply declining.
According to Redfin, a real estate brokerage company, sellers are forced to drop prices. On average, about a quarter of homes for sale during the four weeks ending June 12 had a price drop.
Finally, the surveys of the University of Michigan on Buying Conditions for Houses dropped to a 40-year low.
As long as the real estate market holds, the Fed has leeway to continue its restrictive policy. Actual house prices are not yet declining.
In the last CPI reading, the housing component contributed 1.8% of the 8.6% print. It weighs 32.4%, but it is one of the less volatile components.
Politics and Politicians
Political decisions often act as catalysts. During the next semester, two major political events will likely influence the financial markets: the U.S. mid-term elections and the 20th National Congress of the CCP. But first, let us quickly go over the Ukraine-Russia conflict.
The Ukraine-Russia conflict
Identified here as a critical geopolitical risk for 2022, the Russia-Ukraine conflict primarily affected Europe and, to a lesser extent, the U.S. As we anticipated in this article, sanctions against Russia are ineffective because Russia reduced its exposure to the West and turned towards the East years ago. However, it impacted the West, as Russia is the world’s largest commodity exporter, and economic growth is only the result of commodities' transformation. As mentioned, the current high level of inflation in the West, especially in Europe, is now mainly due to this conflict. In fact, energy prices have room to extend their rise and further complicate central banks’ work of managing higher inflation expectations within a slowing economy. Indeed, the economy has already experienced a much higher oil price before breaking. During the summer of 2008, oil reached $145 per barrel, which, adjusted for inflation is now equivalent to about $200. Moreover, a food crisis is around the corner and uprisings would be a classical consequence.
The consequences of this conflict are much broader. Its resolution would help the market, but only because it would remove one geopolitical uncertainty.
A favorable divided House?
The mid-term elections will be held on the 8th of November, 2022. During this election, all seats in the House of Representatives (HoR) and about a third of the Senate seats are on the ballot. Historically the President’s party loses seats in midterm elections. Additionally, given economic conditions are one of the main factors by which politicians are judged, the HoR will likely turn Republican, as they only need to pick up five seats.
History showed that the best configuration for the market is a Democratic President with a Republican Congress. We believe we may arrive at such an outcome. In fact, since 1944, there were ten years with a Democratic President and a Republican Congress, and the S&P 500 averaged positive returns of ~13% during these periods.
We believe that growth and inflation will be lower by the November elections, and these may act as a catalyst to end this bear market
Around the same time as the U.S. November election, China will hold its 20th National Congress of the Chinese Communist Party. This party congress is held every five years. In all likelihood, the current Chinese leader Xi Jinping will be re-elected, either as the "General Secretary" of the CCP or as the "Chairman" of the CCP. The latter is a title that has not been used since Mao Zedong. However, there are still uncertainties about the composition of the Politburo Standing Committee, given the age of some of its members.
While historically its impact on the economic outlook was mixed, China’s fixed-asset investments tend to grow the most the year after the National Congress. As we have already discussed extensively, this could act as a new catalyst for Chinese investments in technology, healthcare, and renewable energy, the three pillars of its 14th Five-Year Plan.
In summary, we are likely already in a recession, and the Fed is not done tightening financial conditions as actual inflation data does not show a clear downtrend for now. Both higher interest rates and QT reduce the availability of credit and money. It directly affects risk premium across asset classes and also lowers consumers’ demand. Moreover, energy prices should remain elevated hindering further consumer sentiment. The wealth destruction, as well as personal savings, and real disposable income below pre-Covid levels further limit consumer demand. Additionally, our analysis of inflation components suggests that the latter will decline or could even sharply drop within the next 12 months.
Therefore, our portfolios are tilted toward companies with solid balance sheets, that do not need to fund their growth via the private sector, and mainly serve other businesses rather than direct consumers. Also, given the level of inflation and cost pressures on margins, pricing power is an essential component in our sector allocation decision.
We remain highly confident in our various thematic investments. Their structural long-term trends and investment thesis are not affected by market volatility nor by a recession. Innovation will keep growing across industries and the need for technology will consequently continue its uptrend. Artificial Intelligence is the technological fuel for this new innovation cycle. Healthcare has a freeway to thrive thanks to research breakthroughs and the global aging population. Renewable energy is not only at the top of politicians' agenda, but also the entire society is now concerned about climate change.
Moreover, global growth expectations have been going down for more than a year. For our themes, however, the next five-year growth expectations remained at double digits, increasing thus the spread between our growth trend and the global economy, thus our potential outperformance.
Artificial Intelligence & Robotics - (Mid-year review 2022)
Regarding our AI & Robotics portfolio, we reduced our exposure to computing components because some companies were exposed to consumers. We then allocated more to data infrastructure, which not only paves the way for the next AI application phase but also is better positioned to overcome the current economic condition. Indeed, during an economic downturn, companies’ cost-cutting programs involve some forms of automation. The latter needs the infrastructure to expand. As explained here, capital expenditure is essential for the development of AI and both companies and governments are aware of that.
For similar reasons, we overweight our Autonomous Vehicle exposure. Their clients need to cut costs and would likely start expanding the Autonomous Vehicle fleet, especially given the last technological advancements on Level 4 automation.
Note that companies within the Artificial Intelligence & Robotics sectors have strong pricing power and consequently are less impacted by rising costs.
Bionics - (Mid-year review 2022)
Whether a new cycle in hospital spending starts this year or the next, they are already increasing spending in niche markets that enable them to cut long-term costs. Hospitals look to invest in innovative companies within the Mini-Invasive Treatment sector or the Equipment and Devices one. Selling to hospitals or getting their product reimbursed by the government allows companies in this sector to sail through a recession without heavily impacting their sales. Besides, as we have written, companies in this sector benefit from solid balance sheets and no competition. Therefore, we are overweighting the Mini-Invasive Treatment and Equipment and Devices sectors.
On the contrary, we are underweighting Telemedicine because it is a low entry barrier business with no competitive technological advantage. Moreover, some medical services reimbursed in traditional care are not yet reimbursed when using Telemedicine. Thus, during periods of inflationary pressures and a drop in real disposable income, we expect clients to favor traditional care at the expense of telemedicine.
Besides, we also decided to overweight Artificial Organs because its products are reimbursed, removing the cost burden from the patient. Also, this segment targets high acuity diseases, thus mechanically growing adoption.
Finally, we reduced our exposure to liquid biopsy because of its early-stage nature, and the still irrelevant reimbursement level. More importantly, as we have written regarding liquid biopsy, companies in this innovative sector may be forced to raise additional capital to fuel their growth, which may turn out to be more challenging in a tighter economy.
Biotech 360 - (Mid-year review 2022)
The biotech sector is usually among the first to suffer in a tighter economy, growth scare, or recession. Still, it is also the one that may offer great performances when its cycle returns. Given inflation levels and lower availability of money and credit due to quantitative tightening, within the R&D enablers, we underweighted our exposure to the life science tool sector, whose innovative products are expensive. Furthermore, they should receive fewer investments from the big pharmaceutical companies. On the contrary, we increase our exposure to AI and Analytical Services, not only because their clients are well funded, but also because it contributes to their R&D cost-cutting programs. Moreover, this segment benefits from strong pricing power, notably within the SaaS business.
Regarding the drug developers, we overweight the proven therapies such as cell, gene, and immune therapy, each having a blockbuster drug. Moreover, the Cancer Moonshot, a U.S. government program aiming to reduce cancer mortality by half within 25 years, will allow these companies to be funded directly by the government, i.e., without the need for the private sector. However, all the early phase sectors, which do not generate significant sales yet, such as DNA-based and organism-based therapy (e.g., phage therapy, microbiome) are underweighted.
Fintech - (Mid-year review 2022)
Fintech is our thematic that is more cyclical and the most directly exposed to consumers. As a consequence, it is the worst performer so far, year-to-date.
We overweighted our exposure to technology enablers, mostly software developers. They operate in B2B markets and are the less exposed to rising costs. The rising M&A activity for software developers shows that the current valuations are getting attractive, below the intrinsic value. Moreover, traditional banks are doubling-up their IT spending as they see their market share and margins under pressure from the fintech challengers.
On the contrary, we reduced our exposure to alternative lending. Indeed, these companies are highly exposed to consumers, recession risks, and bond volatility.
Security and Space - (Mid-year review 2022)
We are overweighting the space application sub-theme. While they are early-stage companies, they are not short of cash since they just raised money via IPO, and their sales are growing. Thus, they will not need the private sector to fuel their growth. Moreover, one of the impacts of the Russia-Ukraine conflict is to boost space application.
Besides, the need for cybersecurity is so strong that it is independent of macro factors. It is a sector businesses underinvested in, and that is now crucial for any company. Therefore, spending in this segment will be the last to be cut. Companies that are facing economic headwinds cannot afford to have cybersecurity issues arising during a difficult time.
Sustainable Future - (Mid-year review 2022)
The Russia-Ukraine war is reshuffling the cards in the energy sector. First and foremost, it highlighted the energy dependency of Europe and confirmed the absolute need for energy sovereignty for the Old Continent. Second, the underinvestment in the Oil and Gas infrastructure over the past decade will keep energy prices high for the next two years. We believe old producers such as Iran, Venezuela, or Libya will likely participate in increasing the supply to ease the prices.
As we explained here, the European energy crisis started before the conflict between Russia and Ukraine; the latter only amplified it. Energy dependency and high fossil energy prices lead Europeans to massively invest in renewables, starting a new energy CAPEX cycle. They are focusing on renewable, decarbonated energy sources that can grant them some independence vis-à-vis the rest of the World. The new European plan REPowerEU aims to inject €300bn by 2030 in the sector.
Given the faster time-to-market of solar vs. wind, we are overweighting the solar sector and underweighting the wind one. Moreover, despite U.S. anti-dumping investigation in the solar market, both the EU and US governments made it clear they will directly help solar companies, allowing the latter to continue to grow without the cash from the private sector, which is becoming very scarce. Besides, we also decided to overweight the energy storage sector because mass adoption of energy storage is needed for the green energy transition, but also because they can easily pass the higher costs of raw materials to their clients, e.g., EV car makers. This sector will also benefit from a medium-term tailwind of the new European regulation forbidding the sale of fuel-based vehicles by 2035. However, given the potential recession and the lack of disposable income, we underweight the clean transport sector, which eventually heavily relies on consumers. Finally, we believe China is close to a turning point and are overweighting our China exposure in all major sectors.
Inflation trending down. A sharp reduction in various measures of inflation, especially on consumer inflation expectation and headline inflation will give the Fed confidence to stabilize its tightening policy.
Job market deterioration. As the second Fed’s mandate is on a healthy job market, a return to the job market from the early retirees or the Great Resignation cohort will massively increase the unemployment rate. Furthermore, a negative NFP print is not to exclude. However, the job market deterioration needs to be relatively strong to force the Fed to act.
Bad news is good news. Any lousy economic news is eventually good news for the financial markets in anticipation of the Fed’s policy pivot. However, it will happen conditionally to inflation going down.
Inflation stays elevated. No sign of inflation trending down, with services disrupted because of low wages (e.g., airlines), leaving the Fed no choice but to be even more restrictive into a recession, leading us to real stagflation.
Geopolitical risks. Geopolitical risks remain elevated with increasing tensions between the U.S. and China. After the U.S. mid-terms and the 20th National Congress of the CCP, new tensions can arise (e.g., Taiwan). Trades and so prices can be severely impacted, increasing further inflation pressures. Besides tensions around Kaliningrad between Russia and NATO only increases uncertainties.
Higher food and energy prices. Higher food and energy prices not only impact headline inflation, but it has negative implications in all sectors. Global social uprisings are not excluded.
Companies mentioned in this article
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