Crescat Capital commentary for the month of February 2022, titled, "A Trifecta Of Macro Imbalances."
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For the first time in history, the US is experiencing a confluence of three macro extremes all at once:
- High government debt to GDP like the post-war 1940s
- Excessive stock market valuation on par with 1929 & 2000 bubbles
- A resource-driven inflationary crisis environment comparable to the 1970s
Any one of these three economic states endangers the health of markets and the economy. Together they are a highly explosive mix. The disparities have evolved from an era of misguided monetary and fiscal policies. The unwritten plan may have always been to devalue debt by growing nominal GDP through surreptitious inflation. But the ongoing debt expansion, money printing, suppression of interest rates, and deception about the true rate of inflation has only created one of the largest speculative manias ever for financial vs. real assets. At this juncture, policy makers have become their own prisoners. Neither can they halt the rising cost of capital needed to stabilize financial markets nor can they put a lid on inflation.
Whether the Fed tightens or loosens financial conditions, it could only help further catalyze problems for financial markets and the economy. One would accelerate the bursting of historic bubbles in broad equities and credit, and the other would only fuel more inflation, a horse that is already out of the barn.
- Chronic Underinvestment in Natural Resources
The fundamental problem that ensures an inflationary crisis either way, as Crescat’s macro research has uncovered, is the historic underinvestment in critical natural resource industries throughout the energy, materials, and agricultural sectors of the economy. We are convinced that both the investing public and policy making communities underestimate the significance of this capital investment shortfall and its implications.
This historic downtrend has not only constrained the current supply but is preventing future supply from being ramped up quickly. These are the commodities at the core of the supply chain for all goods and services. They represent necessities, including shelter, food, transportation, electricity, heating, and cooling. Demand for these basic needs is inelastic, i.e., not addressed by the Fed’s traditional inflation-fighting toolkit.
A major reason for the underinvestment in these industries has been a well-intentioned but uncoordinated environmental agenda that has obstructed the permitting process and thwarted the attraction of capital to finance new resource projects. The political and social pressure to go green has been massive, but the transitional planning on how to get there from an engineering and economic standpoint has been abysmal. As a result, an economic crisis driven by commodity price shocks is the tradeoff that we will almost certainly face. It will indeed take an inflationary crisis before there is the necessary political will to seriously reconcile these issues.
Driven mostly by technology related companies, global equity markets have grown to an aggregate amount of almost $120 trillion. That is 11 times the size of the overall natural resource industries worldwide. If we exclude the energy sector from this calculation, these industries represent a tiny amount of the global stock market, only 2.5% or $3 trillion of aggregate market cap.
We are finally beginning to see a rush of institutional capital into the resource markets as more investors are looking for ways to hedge inflation, but these industries suffer from a shortage of skilled management and labor to effectively deploy the capital. For example, there has been a decade long decline in college enrollment in geosciences. How can we possibly create a greener planet, including the raw materials necessary for clean energy, let alone our basic needs, when we have been minting less and less earth scientists every year? These imbalances simply cannot be resolved in the short term.
- Fundamental Disparity
Too many years of inexpensive cost of capital and a financially repressive environment have lured investors into going out on the risk curve, drastically increasing their portfolio duration. These shifts in capital allocation have created enormous market inconsistencies. Today, for instance, Apple’s market cap is 40% larger than the entire energy sector. While most people justify this disparity due to fundamental differences, it is important to note that energy stocks generate almost 50% more in annual free-cash-flow than Apple. Will investors still prefer Apple when oil prices break out above $100/bbl?
- As Good As It Gets
After the Covid handout of money to consumers, the government financed a once-in-a-lifetime boost to corporate fundamentals. Sales, profit margins, earnings, and free-cash-flow have all surged recently. But US households also drew their personal savings from record levels to historical lows in the last 18 months, a spending spree that totaled almost $5 trillion. To put this into perspective, that was close to 25% of the nominal GDP pre-pandemic. With absence of organic growth in the economy and fiscal stimulus waning, we believe this fundamental improvement is at peak levels and most of the positive news is behind us.
On top of that, the Fed is being forced to tighten monetary conditions late in the business cycle due the worst inflationary problem in over 40 years. See below a chart of junk bond yields versus profit margins for the S&P 500. Historically, tightening financial conditions lead to profit margin contractions. Another reason for us to believe US companies are currently at peak earnings.
The ISM manufacturing PMI is an economic activity index based on a survey of purchasing managers at more than 300 manufacturing firms. This measurement also tends to lead profit margins for S&P 500 companies by 6 months and is in a bearish divergence.
- Unrealistic Expectations
This notion that equity markets benefit from inflationary environments is a total fallacy. If a business today is incapable of growing at double digits, it is simply not keeping up with true inflation. If we exclude the energy and financial sectors, the median free-cash-flow growth for the S&P 500 is now contracting by -1.61%. Note that these numbers are in nominal terms. With headline CPI running at 7.5% YoY, their bottom-line fundamentals are down almost double digits in real terms. More importantly, Wall Street analysts now expect the largest annual increase in CAPEX of the last 30 years, a sign of the peak of the cycle for all sectors outside of energy and materials.
As shown in the chart below, this happened many other times when economic growth was at its apex. Outside of the tech and housing bubble, or even the meltdown of late-2018, the European Crisis was the only period that did not necessarily coincide with a significant downturn in overall stocks. Instead, the 2011 period was a mid-cycle deceleration.
- Macro Model Flashing Warning Signal
Crescat’s 16-factor macro model helps us identify what stage of the business cycle we are in as it naturally swings between expansion and contraction tied to changes in asset valuations and credit availability. This model encompasses macro, fundamental and technical factors, including some proprietary measurements. Our near-record macro model score is signaling an important bearish signal with current stock prices.
- Rising Wages and Softening Business Outlook to Pressure Profit Margins
After more than 30 years of declining wage and salary growth, labor cost has finally begun to trend upward. Similar to the late 1960s, we think this is marking the onset of secular growth in labor remuneration. The outlook for wages and salaries just reached new highs while business activity continues to weaken. This is another important development that points to a coming squeeze in corporate profit margins from peak levels.
- A Tight Labor Market Often Precedes Recessions
The unemployment rate, one of the best contrarian indicators in history, is now near all-time lows. As shown below, continuing jobless claims are also flashing the same signal.
- Tightening Financial Conditions
After reaching historic lows, credit spreads are starting to widen again, a foreboding recessionary sign if it continues.
Note that junk bond yields tend to lead bankruptcies with a 6-month lag.
- From $18 to 4 Trillion
Global long-term rates, particularly among developed economies, are starting to rise and marking a critical increase in the cost of capital. See below the outstanding value of negative yielding bonds worldwide has been shrinking massively. From over $18 trillion at its peak to $4 trillion today. We think these instruments will become obsolete soon.
- Cost of Capital Mispriced
In a rising cost of capital environment, the size of balance sheets matter. The median weighted average cost of capital for S&P 500 companies is now at its highest levels since 2008. The issue is that, as shown in the chart below, corporations are significantly more indebted than they were back at the peak of the tech and housing bubble .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
