Week of Aug 22, 2022

Opening Remarks:

The most important event of this week is the “Jackson Hole Economic Symposium”. This event, hosted by the Federal Reserve Bank of Kansas City, is attended by some of the most influential global policymakers, academic, and market participants. But one person receiving the most attention is Jay Powell, who is expected to set the records straight as it relates to the monetary policy. His soft stance in his prior appearance was interpreted by some investors as a sign of dovishness. In anticipation of this meeting, the markets have been relatively calm on Monday and Tuesday (Aug 22 and Aug 23).

Last week, we posted our economic outlook in which we expressed our views on inflation, GDP, and macro trends. Although our base case is still a (mild) recession starting in Q1-2023, we’d like to provide some discussions to the contrary and argue that the soft landing, as the Fed is wishing for, might be possible. Here are our contrarian discussion points:

• A lot of comparisons have been made between our current economic conditions and the 70s and 80s. In fact, there are many similarities, but what is not properly considered is the timeline. Paul Volcker had to cause a recession because when he took the helm of the Federal Reserve, inflation had lasted for almost a decade. It’s different now since we’re still pretty early on in the process. Even back then, early attempts to curb inflation were somewhat effective. But the subsequent mismanagement by Arthur Burns that lasted almost eight years created a condition that required a drastic response. The two biggest issues with Burns’ actions were: 1) he was influenced by politics (resulting in cover-ups and taking actions that even he didn’t believe in), and 2) he thought monetary policy alone cannot fix the inflation problem (so he gave up). Chairman Powell is none of these. He did not cover up, he was transparent about his mistakes, and he has taken corrective actions as soon as he could. Chairman Powell seems to understand politics and takes it under consideration when he expresses an opinion, but it’s unlikely that he’ll do something wrong only because of politics. Also, President Biden is nothing like President Nixon (as the pressure on Burns was coming from Nixon). In addition, it seems Chair Powell believes that monetary policy and quantitative tightening are at least partially effective and should be implemented.

• We should recognize that we’re coming out of an unprecedented global pandemic. The rescue packages provided by all governments have never been of this magnitude. Although necessary at the time, such actions come with a price. The pandemic also caused a sudden change of behavior and expectations, which were rewarded by free money indiscriminately, whether or not they were right. We have people suddenly wanting to live in massive houses, needing to change their furniture, buying a second residence, and above all, working fewer hours and getting paid more (just good old fashion laziness but expressed eloquently to justify it). These caused either inefficiency through less productivity, or inflation through excess demand. The statistics show that workers are less productive these days. We can feel it because it seems that problems are not being solved anymore!! (hint: supply chain problems still persists). Adding to this mix was a large amount of liquidity and the technology that allowed everyone to trade stocks. So, we have quite a chaos. We don’t like chaos; it confuses us and make us feel uncomfortable.
  But will all these cause economic collapse and a recession? It depends. If the general population comes to their senses, hopefully after the Feds showed some resolve and tighten the monetary policy, things might go back to normal and even better than pre-COVID because we’re using technology more these days.

• Even with all the tightenings (i.e. rates at 3.5% or even 4%), we’re not far from what used to be normal for maybe a century. In fact, the last 15 years were more of an anomaly with such low interest rates. We know that the prospect of higher interest rates is weighing on the stock market, especially growth stocks. Currently, the terminal rate that is used for valuations is low. Those who believe that stock prices will fall argue that once it's clear that the terminal rate should be higher, the valuations will get adjusted, followed by massive selloffs in the market. First, let’s remind ourselves that the stock market is not the economy. Second, everything is still in flux, so we don’t know how fast things will turn around. Moreover, stock prices might remain high for other reasons. See the next point.

• In the first half of 2022, we had a correction in P/E multiples. The valuations currently are still high but closer to a reasonable range. This is where the ‘earnings’ part of the P/E comes into play. The popular belief is that earnings will diminish due to inflation. But, what if companies are able to pass the prices, or the costs are reduced, and the earnings are adjusted upward (instead of downward.) In that case, will we have prices within the reasonable P/E range? Maybe yes, as the E part of the equation grows and makes the prices more reasonable.
  Perhaps this is not the case with zombie companies. But there are many good companies that are treated just like the rest of the pack. In fact, when we see indices remain unchanged or gyrate slightly, we should always look at the constituents. Quite often, when we look under the hood, some stocks are winning and some are losing. Under this scenario, we won’t have a massive crash, and nor we’ll have a massive uptick. Depending on individual companies, some will win and some will lose.

• In terms of geopolitics, some comparisons were made between the cold-war-era USSR and today China. This is not a good comparison as well. China wants (and needs) global stability and the status quo. It is true that China is moving fast and is closing in, and they definitely want to become the strongest economy, but that doesn’t mean that: first, if they can do it; second, if they can get much ahead of the US; and third, if they can sustain it. US, on the other hand, is getting nervous. But there is another issue in play, and that is politics. There are a lot of incompetent politicians who want to take the easy way and blame their failures on a foreign country. It’s a good thing that the US has decided to dial back on its aggressiveness, and China showed that they have no appetite for escalation. under this scenario, China and the US start getting along better, and perhaps some of the inflationary pressures will be eased.

Why did we bring up a contrarian point of view?

To address the following behavioral pitfalls in investing: conservatism, confirmation bias, herding bias, and recency bias.
Conservatism is when investors research and form an opinion that is correct but do not change their point of view when new information becomes available and challenges the original idea.
Confirmation bias happens when you only seek information that supports your (already formed) idea or point of view
Herding bias is self-explanatory and happens when we follow the herd.
Recency bias is when we put more weight on recent events or events that are significant and easier to remember. For example, the 2008 crisis or even the 1929 crisis is easy to remember and reference.

In conclusion, although the recession is still our base case, we believe that we should consider arguments that contradict our view. This will help us to identify any unexpected pattern before other investors and act accordingly (and hopefully make more money out of it than others).

Economic indicators

Building permits, Housing starts, and Housing completion
On Aug 23, the US Census Bureau released the revised July figures (initially released on Aug 16):
July Building Permits: 1.3% below June permits, but 1.1% above July 2021 permits.
July Housing Starts: 9.6% below June starts, and 8.1% below July 2021 starts.
July Housing Completion: at 1,424,000 units, which is 1.1% above June’s completion.
This data shows the low sentiments amongst builders, especially given that gap between supply and demand is still wide, even with the high number completions.

Durable goods - new orders
On Aug 24, The US Census Bureau released its advance report on durable goods manufacturers’ shipments, inventories, and orders.
New orders for manufactured durable goods in July 2022 remained virtually unchanged at $273.5 billion.
Excluding transportation, new orders increased 0.3%. Excluding defense, new orders increased 1.2%.
Unfilled orders, inventory levels, and capital goods orders increased in the month of July. Shipment of all items also increased in the month of July.
The figures above indicate a strong economy. The only weakness is in transportation (very small) and defense. All other areas appear to hold strong. It also appears that companies have not cut back significantly on capital expenditures.

Unemployment insurance weekly claims
On August 25, The Department of Labor released the claims for the week ending August 20, indicating the adjusted initial claims at 243,000. This is a decrease of 2,000 from the previous week’s revised level.
Therefore, the job market is still robust and no indication of future change in unemployment numbers.

Personal Consumption Expenditure price index (PCE)
On Aug 26, the Bureau of Economic Analysis (BEA) released the July PCE price index. This index is specifically important because the Fed pays special attention to this index. Below are some of the highlights of their release:
- The month-over-month increase in Personal income and Disposable Personal Income was 0.2% and the increase in Personal Consumption Expenditures increased by 0.1%.
- The PCE price index decreased by 0.1%, but PCE excluding food and energy increased by 0.1%. This is consistent with CPI data as well as what we see on the ground that the price of gasoline decreased, but the price of the rest of the goods is still high.
See below the image from the release (modified) so you can see the trend.

Source: Bureau of Economic Analysis

The Kansas City Fed Economic Symposium

Today, at 10 AM EST, Chairman Powell delivered a short but clear message regarding the Fed’s expected course of action. Below are the key highlights:
- Price stability is important and required for future economic growth, but it cannot be achieved in an economy with high inflation. The tools at the Fed’s disposal primarily impact the demand side (not the supply side) but it’s imperative for the Fed to use monetary policy to fight inflation. This will mean higher inflation, a weaker economy, and higher unemployment. The same tools that work well on inflation are going to households in the short run.
- The Fed is determined to follow through with their inflation fight.
- Lessons from the past: the Fed cannot stop its fight or prematurely pivot and raise rates, even in the face of economic hardship.
- Target inflation is still at 2% (some speculated that the Fed might settle at 3%).
- The 2.5% rate is a LONG TERM neutral rate. The neutral rate in short term is higher. This point was made to clarify what he said after July’s meeting. It is quite possible that the Fed will raise the rates up to 4% and stay there for a while.

What was the impact of Chairman Powell’s speech?
Prices start to drop. S&P500 was down by 1.6% around 12:00pm EST. The volume is average, so the movement has legs and might continue further.

Today’s result is in line with our base case forecast (see our economic outlook post). As we try to provide contrarian views as well, below are two reasons that will limit the decline in process to 5%:
- The Fed might dial back on their tough talk once the monetary policy actually hurts the households. It’s easy to talk tough now while the employment is strong. But whether they will hold their position when there are nationwide protests is yet to be seen. With this in mind, some investors might start going long as soon as the prices are down to their expected level.
- The underlying economy is still strong. There are companies that are adopting to the new circumstances and emerging as even stronger. There are some that are weak and bound to go extinct. So, the Fed’s policies might selectively impact companies, but not all. On average, the prices will not decline significantly.
Just one example, which is in line with our contrarian view above is the relationship between the US and China. Today it was announced that China agreed to comply with SEC’s request for oversight over Chinese audit firms engaged in the audit of companies listed in the US. In response to this announcement, the shares of those companies jumped. Perhaps there will be more stories of individual companies that were able to steer through difficulties.
Obviously, these are not our base case. We still think that the market will decline up to 10% within the span of the next two months.

Investment strategy:
We believe that the best approach is to stay away from index or even factor investing and focus on individual companies. Unfortunately, there are bad apples everywhere (due to loose monetary policy) and it all comes down to a strong management team.
In the coming days, we will make a comparison between companies in same sector, analyse their position, and make a bet on one that we think will come out as a winner.