Inflation is high and growth is slowing, but these may be the adjustments that markets need in order to rebalance following acute COVID-related disruptions. Olga and Hugo discuss potential signs of normalization and where investors may find future growth.
Hugo Scott-Gall: The first question I have for you today is quite contentious, Olga. I could fill a warehouse with sell-side research saying we’re going into a recession. You’re saying we’re not. Why isn’t inflation going to take us into a recession, given what it’s causing central banks to do?
Olga Bitel: That’s a million-dollar question, Hugo. In the second quarter of last year, U.S. GDP in year-on-year terms grew by 12.2%. Now we are expecting that the United States may grow by 2% to 2.5%. What that also means is that earnings growth had to decelerate from something like 80%–100% growth down to around 15%–20%. We’ve never seen such a rapid deterioration in growth on that scale in the past 60 years.
In terms of sheer scale, this is not a typical slowdown. And so far, despite everything that the economy has been hit with, it’s actually working as intended. Inflation was a massively complicating factor, but even the inflationary pressures are having the right impact on the economy, meaning that households and businesses are not constrained by policies or regulations in how they adapt. We’re already seeing goods demand rebalance away from post-COVID highs toward services, which is exactly what we would expect in a more normal economy. This gives us confidence that we are slowing not to a recession, but to more normalized and sustainable levels of expansion.
Now, why do we say that we’re hopefully most of the way there? One sign is the Purchasing Managers’ Index, or PMI. A PMI reading above 50 represents an expansion. In the summer of 2021, we were scaling new highs, with the index in the low 60s. PMIs in the low 60s are unsustainable, so we knew that economic activity had to decelerate. In an expansion, PMIs tend to fluctuate around the low 50s, and today the readings are in the mid- to high 50s. The small-business surveys are pointing in the same direction, in both Europe and the United States.
In the first quarter of this year, domestic demand—private consumption and investment—expanded sequentially by a 3.3% annualized rate. So the deceleration in economic growth that we’ve anticipated post-COVID has largely been achieved. We expect GDP and earnings growth to trough in the second quarter. In other words, now.
A lot of commentators interpreted the Fed statement on tightening policy as saying demand is too strong. If we compared pre-COVID trends of both real and nominal consumption, we would see that consumption volumes were growing at about a 4% annual rate. Today we are seeing that aggregate demand growth in nominal terms is above its pre-COVID trend, which is driven by pricing, not by excessive volumes. In fact, as real U.S. consumption volumes are slightly below trend, we do not seem to be in an environment of rampant overconsumption or excessive domestic demand.
The Fed is merely normalizing rates, after an acute and unusual episode of lockdown, to levels that prevailed in the 2015–2019 time frame.
In the second quarter of this year, we expect the market to see that earnings growth is done decelerating. That’s when we expect the end of the slowdown phase of this post-COVID recovery. But we’re slowing to expansion, not to recession.
Hugo: Just to play devil’s advocate, why are you so sure that the U.S. economy can withstand high inflation, rising interest rates, and a negative feedback loop for asset prices?
Olga: Well, when you’re forward-looking, you can never assign 100% probability to anything. This is my base case, and the probability of that is, say, 60% to 70%. There are a couple of reasons for this. The U.S. consumer remains quite healthy. The job market is buoyant, as we all know. Wages are actually rising for the bottom half of the income distribution, which is in sharp contrast to what we experienced in the last decade. That’s unambiguously good for supporting demand growth, because the bottom half of the income distribution disproportionately spends its income. There’s virtually no savings in that cohort. So that buoys your domestic demand.
Inflation is already having an impact on consumer spending. We saw that those categories of goods that were the hardest hit by inflation saw the biggest pullback in demand. Again, the consumer is responding as intended. They’re postponing their large-ticket purchases where necessary.
At the same time, we think the interest-rate adjustment may be closer to the end, at least for now, rather than the start. I’m focusing on the nominal 10-year yield, because most things in the economy are priced off that benchmark. Starting in the 1980s, for about three decades, the U.S. 10-year yield was in a downward trend. After the global financial crisis and since about 2011 or 2012, the 10-year fluctuated around a very low rate. And today, the rates are basically at those 10-year averages. So for U.S. rates to move further from here, we would need significantly stronger economic growth. We may or may not get it, but that would be consistent with expansion, not with a recession.
The Fed and other central banks remain data-driven, so they’re monitoring these trends. The Fed said that once it did this 50-basis-point hike, it would have to look at the data over the summer to see what it does in September. It hasn’t committed to anything yet. The appetite for the Fed to kill the economy is probably very low. Can it make a mistake? Of course it can. But that’s not our base case.
Hugo: OK, let’s talk a bit more about expansion. Would you expect growth to be broad or narrow? Where do you expect to find it?
Olga: Another million-dollar question. The level of growth in any large economy is usually directly correlated with the breadth of that growth. In other words, the broader the growth, the more companies and types of businesses and types of consumers that can participate in that growth, the stronger the overall growth rate.
In the last decade, the United States had subpar growth rates that hovered around 2%. Inflation was anemic, consumer spending was anemic, and growth was very narrow. If we were to escape that and have something more akin to the expansion that we saw in the 2004–2007 period, we are talking about average rates of growth of about 2.5%. Half-a-percentage-point difference per annum doesn’t seem like a lot, but these numbers accumulate.
In terms of who participates, this is where we’re looking for breadth. We predict that the digitization of the economy is going to continue apace. If COVID has taught us anything, it’s that we need to be as efficient as possible, and often, software solutions and digitization afford those efficiency gains. Businesses are upgrading their ability to produce more with less. In that sense, growth is broadening.
The accelerated energy transition that Europe has embarked on because of Russia’s war against Ukraine is going to meaningfully dampen European growth in the near term. But physical investment to upgrade energy infrastructure is likely to happen in both the United States and Europe. If the United States is to transport more liquefied natural gas to Europe, it needs to build export terminals, and Europe needs to build import terminals to receive that gas. Whoever is supplying the capital expenditures for that in the form of equipment and pipes is likely to see better growth in the 2020s than in the 2010s.
Hugo: As the situation in China deteriorates, what impact will its slowdown have on growth in the rest of the world?
Olga: China is definitely a wild card here. Chinese consumption is obviously being artificially depressed, and it may be able to sustain these lockdowns for months, but not for quarters and years. Chinese consumers are not supported in the same way that Western consumers were. So this is having a tremendous strain on households. The Chinese government likely will have to either start compensating people or figure out a way out of the current predicament within weeks.
Lockdowns in China exacerbate the challenge of domestic inflation in the United States. When China does reopen, the rebound is likely to be significant, just like we saw in the West. So, within a couple of months, we may see another uptick in inflation. But this is now occurring against the backdrop of slowing growth, not accelerating growth, so its impact is likely to be smaller. China is posing another headwind, but crucially, this time, the growth in neither Europe nor the United States relies on a Chinese bailout, as it did in 2009.
Hugo: If we take your base case—acknowledging that the forecast error is quite high, and the distribution of outcomes is quite wide—expansion should lead to positive earnings revisions. Do you think that, on an aggregate basis, market multiples are now reflective of an equilibrium real rate, or do you still see some headwinds there?
Olga: In expansions, we normally don’t get any help from multiples. Market leadership is driven by the strongest earnings growers. If we look at the period of 2003–2007, global corporate earnings averaged at around 15% growth. Stock market returns at that time were entirely driven by earnings growth. Furthermore, we think that multiple contractions will largely stop when earnings growth ceases to decelerate. We think we’re closer to the end of that, and we’re seeing that in aggregate revisions.
Tentatively, we’re seeing the premium for quality coming down, and the multiples have compressed. Looking forward, it’s all about earnings growth.