Separating the wheat from the chaff
As markets stumble forward into earnings, winners and losers likely to emerge.
One of my favorite paintings at the Met in New York City is Vincent van Gogh’s masterpiece, “Wheat Field with Cypresses.” Within the idyllic backdrop of a golden wheatfield framed by a tall cypress grove on the right and an azure sky above, the viewer sees that a summer storm has passed, and golden rays of light now warm the field. Then the viewer’s eye is caught by a movement happening within the wheatfield. Something is stirring. Is that just a benign, gentle breeze, or something scarier? And is that cloud above entirely a “fair weather cloud,” or is it roiling in some unpredictable, even dangerous way? My guess is that Van Gogh’s tortured mind perceived a little of both; we know from his letters he worried about the final judgment, when the wheat would be separated from the chaff, the winners from the losers.1
As we approach third-quarter earnings, I can’t get Van Gogh out of my head. While the storms of summer may have passed, clouds are still looming and the path ahead not entirely clear. Has inflation truly peaked or was today’s PPI print a worrisome sign that another bout of inflation lies ahead? Is the Fed truly done? And even so, how long can the economy handle “higher for longer”? When if ever will higher rates really start to show up in economic growth? Is China ever going to rebound or is it entering its own version of Japan’s “lost decade”? Does Artificial Intelligence help or hurt these trends? What about rising geopolitical risks? And most importantly, what will earnings be like in this environment? Will higher nominal GDP mean higher earnings ahead, or will cost pressures drive down margins and pull earnings lower, not higher? Readers of this space know that our answer to these important questions is somewhat nuanced. With macro concerns fading, we think the mixed pressures implied above will generate mixed outcomes within and across industries, and importantly across companies. Like Van Gogh’s “Wheat Field,” a harvester is coming and winners and losers will emerge. And we expect this quarter’s earnings season to begin to drive this point home. Enter the stock picker.
Let’s review some of the mixed macro forces the market is working through as the Rocky Landing enters its 23rd month, as well as how this mixed data is creating winners and losers within the stock market.
- Oil higher for longer. The extraordinary inflation prints we first began experiencing in late 2021 were driven by several factors, including several post Covid “one-offs” that are now diminishing: supply chain shortages, labor shortages, excess demand for services from a newly freed consumer that had been locked down for two years, excessive monetary and fiscal stimulus that had been put in place due to the Covid emergency, and a spike in commodity prices, in particular oil. While most of the forces on this list have now dissipated, two remain an issue: oil and labor. Regarding oil, we have entered a period of structurally constrained oil supply, partly driven by government policy to reduce carbon emissions, and partly by capital constraints on energy companies discouraging production expansion. So, unless a sharp global recession suddenly appears (not our view) or the Israeli conflict expands well beyond current borders (also not our view), oil prices appear well supported and likely to remain broadly in a higher-for-longer pattern, between $80 and $100. This alone will pressure nominal inflation prints in the months ahead, such as we saw in the monthly PPI print of 0.5%, which annualizes at 6.0%. However, in the “mixed message” column, I’d note that the “core, core” print at 0.2%, annualizes at only 2.4%, very close to Fed’s target. We’ll see if the nominal numbers lead core or core the nominal in the months ahead, but our view for now is that with oil structurally higher, and labor still structurally tight, inflation ahead will prove difficult to bring down below 3% for much of next year. One area we like, given these developments, is the energy space, where “higher for longer” is driving very strong cash flows and ever improving balance sheets, even while stock valuations remain depressed by concerns about the recession that all the pundits assure us is “just around the corner.” Losers, we think, are companies facing off against the consumer, particularly those serving lower-income consumers most negatively impacted by higher oil. These companies are finding it ever more difficult to pass through rising input costs into prices, and many will struggle to avoid further earnings downgrades.
- Labor markets structurally tight. Another issue ahead that’s both positive and negative is that labor markets remain quite tight, with unemployment stuck at very low levels. While this worries the Fed for sure, as do the well-publicized labor strikes such as the UAW’s, the good news is that wage inflation is gradually coming down, even as more and more workers return to the post-Covid labor force, bringing the ratio of jobs on offer to unemployed continually lower. For the broader economy, labor markets to us present something of a “Goldilocks” scenario, strong enough to keep personal incomes rising (both through added jobs and wage growth), yet still competitive enough to keep wage gains moderating. Winners from this theme will be companies who’ve managed to maintain better employee relations, rising labor productivity and less punishing wage increases; losers are ones without scale economies, poor labor relations/union strikes. Interestingly, this effect is likely to separate not just “labor light” industries from “labor intensive” ones (i.e., favoring tech, hurting food retailers or autos), but also it will separate companies within industries who have different levels of unionization and/or labor problems.
- Interest rates likely to remain higher for longer. With both oil prices and labor costs structurally high, it is no surprise that the Fed is signaling its intent to keep interest rates elevated. Rates higher for longer will keep pressure on areas of the economy that are most rate sensitive, especially since the Covid-era borrowings that were put in place at lower levels will gradually run off in the quarters and years ahead. One area we are watching closely are highly levered corporates that will come under increasing pressure as time passes and interest rate payments begin to reset to the new environment. On the other hand, there are many companies, especially within the S&P 500, that enjoy pristine balance sheets and robustly positive free cash flow (think especially technology companies, energy stocks). And again, this will lead to winners and losers within industries, as companies with better balance sheets find themselves with more flexibility than their industry peers with poorer ones.
- Artificial intelligence for real. Given the speed with which AI has seemingly burst upon the scene, it is tempting perhaps to consider it a passing fad or a flash in the pan. Our analysts following AI have concluded differently; we think it is very much for real, and likely to lead to both another round of capital spending across multiple industries, and importantly a new leg of productivity improvements across the economy. Winners here are both the well-publicized “big data” companies that have been the early leaders in the field, but also other companies who stand to benefit from productivity gains by utilizing AI tools to either adapt their pricing models ever more finely, customer by customer, as well as to cut back high cost workers from computer coders to customer order takers. Losers will be companies that struggle to incorporate AI within their business models, either because there are no obvious applications and/or because they lack the financial flexibility to invest.
- Geopolitical risks rising. Given this week’s news flow out of the Middle East, no list of uncertainties ahead would be complete without discussing the ever-rising geopolitical risks around the world, from the emerging cold war with China, the intractable Ukraine-Russia conflict, and now this horrific war in the Middle East. With so many voices weighing in on the politics of all this here, I don’t have a lot to add other than compassion and grief for all concerned. On a markets front, there seem to be three intermediate-term transmission mechanisms to consider. One, risk premiums in general are likely to rise, pressuring P/E multiples and equity returns. This seems to resonate with our view that we are now in a winners and losers world. Second, oil prices aren’t going lower. This helps the energy stocks and adds another reason to like them here. Third, defense spending globally has to go up. Good for defense stocks, which interestingly have generally underperformed YTD but are now showing signs of life.
So, as we enter the fourth of quarter of what has been a tough year for stock pickers, we see some fair weather ahead. With the economy likely downshifting to a slower growth mode, and conflicting forces buffeting the global economy, a winnowing is coming. Winners and losers are emerging. Stock pickers may yet have their day in the sun.
1 Stephen F. Auth, Pilgrimage to the Museum, Sophia Press, Manchester, NH, 2022.