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Global GDP is slowing. Central banks are raising interest rates and tightening money supply, all except for China. Corporate profits are slowing, except for the energy sector, where they are gushing. The dollar is strengthening. That puts a crimp on U.S. companies that sell goods abroad. And there is geopolitical uncertainty, starting with Russia's continued invasion of Ukraine but popping up in other hotspots around the world as well. You add climate disasters into the equation, and the pot gets a little hotter.
Consumer sentiment, as you might imagine, is really weak and is correlating pretty closely with investor sentiment these days. According to Investopedia's latest sentiment survey of our daily newsletter readers, 57% of respondents say they are worried about recent market events, with 25% of them saying they are very worried. The steep sell-off in stocks, especially popular tech and consumer staples stocks, has also eroded trust in the stock market, with 46% of respondents saying they trust the stock market less than they did six months ago, an 8% rise from April.
Forty-seven percent of respondents expect the stock market to trade lower in the next six months, with more than one-third expecting a decline of 10% or more from current levels. After last week's drubbing, we're only about 5% away from that additional drop. All of these concerns are prompting our readers, who are individual investors, to play it safer with their investments, according to our survey, or simply stay put. Forty-seven percent of respondents say they are playing it safe or seeking refuge in cash, bonds, or low-volatility ETFs. That's up 9% since April. Forty-three percent of respondents say they are staying the course with their investment allocations, hoping the tide will turn.
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Seema Shah is Principal Global Investors' chief global strategist. Originally joining the firm back in 2010, Ms. Shah previously served as a strategist within Principal Global Fixed Income. Prior to joining Principal, she worked as an economist at Capital Economic, as part of the macro consulting group at PricewaterhouseCoopers, and as an economist at HM Treasury. Additionally, Ms. Shah is frequently quoted by financial news outlets and has regularly appeared on both CNBC and Bloomberg TV.
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Recession or no recession? That seems to be the predominant question circling around capital markets and the global economy these days. And the more we talk about it, the more it feels like we're conjuring it into being. Or maybe I'm just being paranoid. Recessions used to be characterized by two consecutive quarters of negative economic growth. But these days we refer to it as a downturn across a variety of leading economic indicators that goes on for several quarters. No matter how you classify it, we know it when we're in one, and we don't know it until it's over and we've cleared it. Seema Shah has studied more than a few economic cycles and market behavior in her career. She is the chief global strategist at Principal Global Investors, where she oversees global market strategy and advises the investment team at Principal on asset allocation. She is also our very special guest this week on the Express. Welcome Seema.
Seema:
"Hi Caleb. Thanks for having me here."
Caleb:
“In one of your recent notes, you say the threat of a near-term recession is pretty low, but it increases when we look out to the next 12 to 24 month period. That’s not great news for investors, even though markets don’t always decline during recessions. But why does the future look so dim when the present seems to be pretty complicated too?”
Seema:
“It’s a really important thing that we’re talking about at the moment, because what I’m finding is investors are taking a lot of comfort from the current strength of the economy, but they’re ignoring the monetary policy. It typically works with a six-to-24-month lag. So, whatever happened today with the Fed is not going to be showing up in the economy for several months, several quarters, still.”
“But we also look at consumer spending. That is particularly strong and that has been held up by the cushion of excess savings provided during the COVID crisis. We look at the labor market, unemployment rate close to the pre-COVID lows, and extremely tight, really, really strong labor demand. But you fast forward 12 months from now, and consumers are going to be struggling because time and inflation is going to eat away at a lot of that excess savings, especially for your lower-wealth thresholds of the economy. You look at the labor market, and so many companies are struggling with the margin pressures from higher costs. And you can start to see that temporary help, which is usually your main leading indicator for the labor market, is starting to decline. So, 12 months from now into 2023, things are going to look very different from a number of economic indicators.”
Caleb:
"They're suffering from price inflation across the goods that they buy. They're suffering from wage inflation for the people that they employ. And you said it, we're already seeing some softness, especially in the retail sector. A lot of temporary employees there. You're seeing some softness in the labor market here in the U.S., probably worse around the world. You've got… Principal manages some $580 billion here in the U.S. on behalf of clients. What's their predominant concern right now? Is it inflation? Is it wealth preservation? Who are these clients, and what do they care most about?"
Seema:
“So, the thing that seems to come up in every single conversation that we have with them, which it is absolutely right to be questioning this, is in this inflationary environment when you know that the Federal Reserve and other central banks around the world are going to be hiking really aggressively, how on Earth can markets continue to outperform? Is this the time to go in cash, or is there any opportunity within the market? And look, it’s really important… this is not the time to cash out. This is the time to become more clever with your investing. So, more selectivity and more understanding of where you are allocating. Because we can’t hide away from this. Things are going to get tougher.”
“In the last ten years, because the Federal Reserve and other central banks have been providing so much liquidity into the market, companies haven’t had to do too much to do well. Investors haven’t also had to do too much to do very well. But as you start to see this retrenchment of liquidity from the markets, central banks start to tighten as you see slightly weaker growth. And as you have inflation higher than what we’ve been seeing over the last couple of decades, your traditional asset classes will be more challenging and we have to generally get more used to lower returns and high volatility. So, this is a very different investing environment than we’ve been used to over the last decade.”
Caleb:
“Yeah, we know we’re not going back to the way things were for the past 10 to 12 years, that 0% to 0.25% interest rate level from the Fed. We know inflation is obviously higher than the below 2% where it was for so many years, stuck there for so many years. The game has changed. The sector performance has changed as well. Do you think, given what’s happening in commodities and in fossil fuels, we’re in the beginning of a supercycle for commodities?”
Seema:
“This is the key question right now. One of the other questions, which is, again, very much related to inflation, is commodities are up, but have we missed the opportunity to get into the market? And we kind of missed the major rally. The commodity cycle that we’re seeing is not just because of the Russia-Ukraine crisis and what we’re seeing in the awful events there. It has propped up commodity prices even more, but there has been… one, there’s been improved demand because of the post-COVID recovery. But more particularly, there is a structural shortage of so many commodities because of decades of underinvestment.”
Consumer prices jumped 8.6% year over year to the highest level since December of 1981. Back then, just before President Ronald Reagan took office, the federal funds rate was 13%. Today, it’s below 1%. The biggest contributors to the consumer price spike is gasoline, up over 70% in just a year. About 70% of the gas price spike has come since Russia invaded Ukraine in February. The price today is over $5 a gallon on average across the United States. The price a year ago: $3.08. The price the day Russia invaded Ukraine: $3.54. More drivers are running out of gas on the road because they can’t afford to fill their tanks. Triple A fielded 50,787 out-of-gas calls in April, a 32% jump from last year.
“So, this commodity cycle that we’re seeing, it is not going to go anywhere soon. We will continue to see upward pressure on a lot of these commodity prices going further. They may not rise at the same pace that we’ve seen over the last six to 12 months. But are they going to go back down… will you see oil prices back down to the $75, $50 a barrel in the near future? It’s pretty unlikely. So, we have to take into account the current demand events but also, more importantly, the structural supply shortages facing this market. And from that perspective, commodities, real assets in general, is actually where we see the most opportunity for investors right now.”
Caleb:
“And that’s so different from where we’ve been because we’re coming out of the knowledge economy era. We’ve seen these Big Tech companies, super-high margins, intense growth, all of that fueled by low interest rates and also a very intense appetite on the part of consumers. And now we’re in this period where commodities become the thing, and you’re seeing it and you see it in the retailers here in the U.S., what economists like you like to call the bullwhip effect, right? They don’t have the goods that consumers want. They weren’t prepared for it. If you see that at the retail level, take that all the way back to the producer level, the folks that are actually producing these commodities, they weren’t prepared for it either, were they?”
Seema:
“They weren’t. And we have seen, and we’ve seen this from a lot of the earnings results over the last couple of weeks, so many of these companies have unfortunately mismanaged a lot of their inventories, but they had not necessarily foreseen the fact that supply chains would resolve. They overall did. And they assumed, most importantly, that consumers would continue to pay the prices, they’d be able to pass on these price increases to consumers. But it’s unfortunately not the case anymore. So, you are starting to see these firms struggle.”
"But I do want to come back to tech though. It has had a particularly challenging five or six months. We've undone a lot of the gains that we've seen since the COVID recovery. Does that mean that this is the end for tech? Well, it depends which part of technology you're looking at. The nonprofit tech that is absolutely challenged because they have no way at the moment of proving that the future is going to be particularly strong. So, we almost set that aside."
“But then you think about the mega-cap tech. This is your Amazons, your Googles, and all of those really, really big names that we’ve become accustomed to. Microsoft, they have a secular growth story. Do we think going forward that, as companies think about where are they going to invest going forward over not just the next two years—we’re talking about the next five, ten, 20 years—do we think they’re going to stop focusing on technology? I mean, absolutely not. We know that technology is the future for everything. So we have to think about that technology may be challenged in the near future, but this is a secular theme, especially for investors. And if there is one bit of advice I’d give anyone is, look away from the day-to-day headlines of things that may be concerning. You’ve got to look at the fundamentals, and you’re going to seek out where are your long-term themes. And that’s what’s going to carry a lot of these companies over the threshold over the next couple of difficult quarters.”
Caleb:
“So hard for investors to do that when our animal spirits are having us focus on the headlines, they’re blaring at us from every which way. And we’re coming off of three years of intense gains here in the U.S. and the capital markets here, only to find in the past six to seven months a very, very weak market and a complete turnaround where value has led, growth has definitely slipped into the back of the bus here. And it’s a very challenging environment because investors in the U.S. are so weighted in the tech and the big indexes are so heavily tech-skewed. I know you look at the global economic picture when you do your research, and there aren’t that many countries in great economic shape right now. We know inflation hurts the poorer countries the most, but where, from your perspective as you look at the world, are the real danger zones in the world today?”
Seema:
“Well, for me, the main danger zone is going to be emerging markets. You know… you going to hit those commodities theme throughout this? Because we think that food prices, another commodity, is going to be really under significant pressure going forward, we’re going to see food prices rising even more than they already have. And which countries are the most exposed to this? It’s really a lot of these emerging markets. Some of them are what we… frontier markets we don’t typically see a lot of retail investors looking at.”
“One of the danger zones, though, is you have frontier markets… the problems from frontier markets typically ripple into emerging markets. So, once emerging markets, then there is sometimes a repercussion onto developed markets as well. So, we have to be a little bit careful again about emerging markets. Not all of them. There are going to be some pockets. I’ll give you an example of China, which can do well. But there will be a majority of emerging markets that we do think will be very challenged over the next quarter or so.”
Caleb:
“You got to pick your countries very carefully. You got to pick your companies very carefully. It’s a time for really thoughtful investing and good guidance, which is something I know you believe a lot in. So, we’re not going back to the days of that hypergrowth that characterized the past decade. We talked about that, but we’re starting to hear the drumbeat now about stagflation. Treasury Secretary Janet Yellen brought it up recently. We’ve seen that in Japan. We’ve seen that in the U.S. back in the 1970s. That is not a good investing environment. Is that where this is headed?”
Seema:
"So, I shy a little bit away from the usual term of stagflation. There's a lot of different definitions of it. Let me term it like this: We are going into an environment where inflation needs to be brought down, and it will come down. When you have the Fed hiking as much as it is, it will slowly, slowly come down. But alongside that, you will see slowing growth because when the Fed has to bring inflation down to such heights, really the only remedy to high inflation is essentially going to be a recession. So, that is what we are looking at. Inflation will come down, but along the way it will be brought down by slowing growth."
Caleb:
“Okay, good to know. You have these counter factors. You’ve got the inflation that’s pretty stubbornly high. And if you look at consumer projections, they’re looking at 5.3% inflation over the next 12 months and then somewhere in the 3% to 4% for the next few years. If you look at the GDPNow tracker, that’s got it kind of in that same range, maybe a little bit higher in some instances. But how can we really know when we don’t know how certain things are going to unfold, namely Russia-Ukraine, but also the intense demand coming for commodities and especially the fossil fuel sector right now. How can you really pinpoint where inflation is going to be other than surveying it and seeing where it’s been historically?”
Seema:
“It’s a good question. What I think we look at the inflation… we have to start thinking about… not just focusing on the hard numbers that we see, the CPI numbers, that come out month after month. This is about really understanding what the companies, what the CEOs around are telling us. What are the pressures that they are facing? They’re seeing real-time evidence. And that’s going to be the guide for us on how inflation is performing. Is it coming down quickly, or is it going to go down very, very slowly, which is what we suspect will be the case?”
Caleb:
“And if you listen to what a lot of the CEOs are saying, from Target to Walmart, even the Big Tech companies, they don’t see it going anywhere any time soon. So, that’s why they’re dealing with their inventory issues now, taking the write-downs if they have to. You’ve got to listen to what they say on their conference calls. And that’s really been a theme that keeps coming back. So, what are the top three forward-looking economic indicators you’re focusing on for the next 12 months that could give us a little bit more market direction, that could give us a sense of where this is going to head? Are there two or three that are just top of mind for you?”
Seema:
“Yeah, absolutely. I think investors, of course, will be watching the labor market, but the key one to watch is temporary employment. And the reason I say that is typically you see the payrolls numbers… that is one of the last things to fall. Employers usually cut job postings, and they cut temporary help. Those are the first things to go. So, that’s giving you an indication how quickly the labor market is starting to slow.”
"The second thing is, and this is a little bit more difficult because there's no specific data point that would be watching, but you just have to watch the consumer. How resilient is a consumer, and how much longer can this consumer start resilient? For that, I just watched the earnings calls we're going to hear from Guidance. What are the companies telling us about the ability to pass on some of these higher prices to consumers?"
"So, those to me are the two key things. And then if I could just add in a market indicator, it's going to be financial conditions. Financial conditions, if it comes down quick enough, that may be enough to see the Fed slightly slow down the hiking pace, which would add an element of optimism back into the market. But unfortunately, the financial conditions, they need to tighten significantly first before the Fed to get its foot off the brake."
Caleb:
"Well, I love your metaphor that you wrote about the Federal Reserve, likening it to a high diver that is diving from higher and higher platforms, attempting not to make a splash. Can the Fed engineer a soft landing or a splash-less dive as we get higher and higher and the stakes get higher?"
Seema:
"The Fed has attempted it many times in the past, and they have a very, very unsuccessful hit rate. We would expect there to be a significant slowdown. We are expecting recession to hit in early 2024. If you look back on time, every time the unemployment rate has gone up by more than 1%, it has been accompanied by a recession. And you think about what the Fed is trying to achieve. They are looking to see the labor market un-tighten. So, you start to see that increase in supply and a drop back in demand. And that typically means a rise in the unemployment rate. So, history is telling us that the Fed could achieve it, but the chances are very, very slim."
Caleb:
“You got a lot of investors. You got a lot of money under management. There are a lot of folks who do this passively or they work with your advisors or they work with your teams to put together the portfolios. But what is the overall strategy called for folks who are passively invested in the market? They don’t like stock picking. How do you navigate a period like this going for the next 18 months to two years?”
Seema:
“The first bit of advice I have is, it’s not timing the market. Timing the market, timing the bottoms, timing the tops is extremely difficult. The key thing that you need to focus on is time in the market. Pick out those secular themes. As we talked about before, commodities is key going here. So, we think about real assets. We think about stuff like infrastructure, which actually, in an inflationary environment… and I should say, the next decade, we’re not going to see inflation back down to the kind of 1–1.5% level that we’ve seen over the last decade. This is a higher inflation environment going forward, and in that situation, you need to have exposure to stuff which is almost inflation insensitive. And that’s where stuff like infrastructure comes in; commodities, of course, as we’ve been talking about as well.”
“And then within the equity space, there is a call to be a little bit diversified but almost not take a very significant hit on either the growth or the value place. So, we are relatively equally balanced across growth and across value. The thing that we try and look for is, ‘Where are the sectors?’ If you can’t look at companies, that’s fine, but look at the sectors at least where… typically have the greatest balance sheet strength. Which are the ones that have the least leverage? Which are the ones that have the more persistent, stable cash flow? Those are typically the places that will outperform in a more challenging economic environment. So, there are spaces, but they just need to be sought out.”
Caleb:
"Good time to know your fundamentals, and a good time to know how to read a balance sheet or follow folks like Seema Shah, who does it for a living. You know we're a site built on our investing, finance, and econ terms. You're a trained economist. What's your favorite investing term and why?"
Seema:
“The term that’s most resonating for me is, and we may hear about this as an abbreviated term, it’s FTV: fundamentals, technicals, valuations. For any kind of investment, if you’re thinking about companies, you’re thinking about sectors, you’re thinking about regions, even thinking about asset classes, it comes back to those fundamentals, technicals, valuations. Which ones are telling you that this is an opportunity to get in? And which ones are telling you that this is a time to maybe reduce your exposure?”
Caleb:
"We love that. You put three terms into one. We've never had that before. We're going to give you that, and that is yours alone. Seema Shah, the chief global strategist at Principal Global Investors. Thanks so much for joining the Express."
Seema:
"Thank you, Caleb."
It’s terminology time. Time for us to get smart with the investing and finance term we need to know this week. And this week’s term comes from Matthew Gum, who sent us an email with his suggestion. Matthew suggests demand destruction this week, and he says he listens to many financial podcasts and this term keeps coming up. Well, the Express is here to make sense of it for you. We spoke about it earlier on the show, but let’s hit up my favorite website for the actual definition of demand destruction. Well, according to Investopedia, in economics, demand destruction refers to a permanent or sustained decline in the demand for certain goods in response to persistent high prices or limited supply. Sounds kind of familiar. Because of persistent high prices, consumers may decide it’s not worth purchasing as much of that good or seek out alternatives as substitutes.
Demand destruction is most often associated with the demand for crude oil or other commodities. We're seeing demand destruction right now. It's happening in the U.S. housing market, given high prices and high mortgage rates. And we're starting to see it in the retail gasoline market, believe it or not. Fill-ups for gasoline actually fell 5% in the past six weeks as drivers didn't fill their tanks all the way, they carpooled, or they simply drove less. In the retail sector, we're seeing demand destruction from that unwanted inventory that is sitting in the warehouses of Target, Walmart, Home Depot, Best Buy, and others. Indoor and outdoor furniture, high-priced electronics, sweatpants and leisurewear, that was so 2020 and 2021, but now nobody wants it. Demand destruction at work. Good suggestion, Matthew. Investopedia's finest socks are coming your way in the mail.
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