Amidst the supply-side-driven regime change that we believe has unfolded across the global macroeconomic landscape, we continue to advocate for ‘Keeping It Simple’ in today’s market. Key to our thinking is that an investor can now earn strong risk-adjusted returns without the need to stretch in terms of either capital structure or counterparty risk. Consistent with this view, we believe investors can create some really attractive vintages in both the private and public markets by doing the little things well, including maintaining linear deployment, ensuring diversification through sound portfolio construction, and hedging currencies and interest rates where appropriate. In terms of what this backdrop means for investing, in our view, now is a really compelling time to be a lender on a global basis. This vintage should not be missed. We also continue to pound the table on the benefits of collateral-based cash flows in portfolios, particularly Infrastructure, Asset-Based Finance, and certain Real Estate projects that are directly linked to positive nominal GDP growth. Finally, within both Private and Public Equities, we remain thematic in our approach and steadfast in our desire to focus on high free cash flow conversion stories, especially corporate carve-outs and public-to-private transactions.
You have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains.
No doubt, there is a lot of ‘complexity’ out there to distract investors. In particular, we have escalating China-U.S./Western tensions, a full-scale invasion of Ukraine by Russia, bank failures, increased political divisiveness, and a surge in AI-related breakthrough technologies. At the same time, central bankers are still trying to unwind what was possibly the greatest coordinated flush of monetary and fiscal spending during COVID that the developed market economies have ever seen.
Yet, despite all this uncertainty, the S&P 500 is up around 14% year-to-date, while the Euro Stoxx 50 and the Japanese Topix have each appreciated about 15% and 20%, respectively. Meanwhile, High Yield bonds have produced a total return of just over five percent year-to-date. Has the market got it wrong? What does this all mean on a go-forward basis? Our take: After multiple trips across Asia, Europe, and the United States to pressure test our macro frameworks in the first half of the year, we think investors are still too conservatively positioned for the path forward we are seeing for the global economy.
Without question, we are all experiencing a complicated, asynchronous global economic recovery following COVID, and we still expect negative EPS growth in 2023. However, similar to what we laid out in our 2023 Outlook note Keep It Simple, we actually remain constructive on risk assets, given stronger nominal GDP growth than in past cycles (Exhibit 1). Rarely has there been such an intersection of poor near-term fundamentals, more than offset, we believe, by a compelling technical backdrop (i.e., little new issuance supply, record buybacks) and resounding negative sentiment (S&P 500 shorts are near 30-year highs); at the same time, recent dislocations have created some stand-out investment opportunities that traditional 60/40 investors might be overlooking. Against this noisy backdrop, Steve Jobs’ famous words that “You have to work hard…to make it simple” resonate mightily with us. But if you do, the upside is significant as “you can move mountains” as an investor, we believe, in this market.
Key Considerations
EXHIBIT 1: It’s Actually Been the Fastest Economic Recovery Since the End of World War II
U.S. Nominal GDP Growth 12 Quarters Into an Expansion Cycle, %
EXHIBIT 2
While Inflation Likely Has Peaked, We Believe a Regime Change Has Occurred
In case there is any question, we want to be on record that we think that the bottom is in for the S&P 500 this cycle, and that it occurred back in October 2022. Similarly, within Credit, our view is that prices are likely to stabilize in the current $85-90 range, and while we expect an increase in defaults, we think the longer-term path is upwards from current levels.
Importantly, we do not think that a CIO can broadly go risk on and/or risk off. Key to our thinking is that the current economic signals are just too varied, which actually makes sense given the supply side shocks we are all experiencing this cycle. Indeed, as we show in Exhibit 3, our proprietary four stage model has important inputs actually spread across all different phases of growth (i.e., contraction, early cycle, mid-cycle, and late cycle), and as such, we are experiencing both a rolling recovery and rolling recession at the same time. In the past, by comparison, most of our inputs would concentrate in just one of the phases.
EXHIBIT 3
Our Proprietary Framework Suggests That Cyclical Leading Indicators, on Net, Are in a Mild Contractionary Phase in the U.S. Importantly, We Do Not Expect the Same Type of Economic Downside as in Past Cycles, Especially on a Nominal Basis
What’s Different About This Recovery? Here’s What You Need to Know
| Constructive/Unusual | Challenges |
|---|---|
Strong Technical Backdrop Low Unemployment Amidst Strong Nominal GDP More Fiscal Spending Monetary Easing in China Offsetting Tightening in the U.S., Europe, and Japan |
Stickier Inflation Significant Margin Degradation Debt Burden Accelerating Potential for a 2024 Snapback More Limited |
Where We Differ From Consensus
| Stronger GDP Growth in 2023, Especially in the U.S. | We are above consensus for growth in the U.S. and China for 2023. Our biggest outlier is the U.S., where we are forecasting Real GDP growth of 1.8% versus consensus of 1.1%. Though we are more conservative on growth in the developed markets in coming years, we think the biggest surprise this cycle may be that growth does not slow as soon or as disastrously in aggregate as the consensus now expects. |
| We Are Below Consensus for Inflation in Every Region for 2023, But Higher in 2024. | We are below consensus on inflation in the U.S. (four percent vs. consensus of 4.1%), Europe (5.3% vs. consensus of 5.5%), and China (1.0% vs. 1.5% for consensus). By comparison, as we head into 2024, we remain above consensus in Europe and the U.S. as a result of higher ‘sticky’ core inflation and in China as well because of easier year-over-year comparisons. |
| Regime Change: Inflation Will Remain Higher This Cycle | Although the TIPS curve suggests inflation will be below the Fed’s two percent target over the next twelve months, we continue to believe in our ‘higher resting heart rate’ thesis as the crucial disinflationary forces of the last ten years (globalization, lower energy prices, and a labor surplus) have all largely reversed course. Our forecasts suggest that by the end of next year, inflation will have been above the Fed’s/ECB’s two percent target for 16 out of the last 20 quarters in the U.S. and 14 out of 20 in Europe. |
| Earnings per Share: Less Bad in 2023, But Less Rebound in 2024 | We now expect EPS to decline five percent in 2023 to $210 per share, below consensus of $220 per share. Key to our thinking is that despite positive topline growth, profit margins are starting to contract more meaningfully. Importantly, we believe growth will slow further in 2024 and see a muted rebound of eight percent to $227 per share versus consensus of $245 per share. |
| Developed Markets Labor Shortage Is Not Going Away | Our work suggests that the U.S. is short of workers on a structural basis, as lower participation rates collide with souring demographics and reduced immigration. So, we are not going back to the ‘good old days’ of labor surplus, even as AI helps to lift some of the burden. |
| Oil: $80 Is the New $60 | Near term cross-currents notwithstanding, we remain constructive on the structural outlook for energy and energy-related investments going forward. We think impressive capital discipline by U.S. producers could support durable long-term pricing that averages closer to $80 per barrel, up from the pre-pandemic range of $50-60 per barrel. |
| Housing: This Is Not the GFC | While it is likely too soon to be bullish on U.S. housing relative to investor expectations, the big surprise may be that housing doesn’t collapse back towards the pre-COVID trend. We think much of the home price appreciation in recent years reflects strong fundamentals such as accelerating household formation and a legacy of underbuilding post-GFC. |
| Interest Rates: Higher Long-term Yields in the U.S. and Germany | While we see the bund yield rising to 2.75% by the end of 2023 and three percent by the end of 2024, consensus looks for just 2.3% and two percent, respectively. Our thinking is that the impact of ECB balance sheet contraction and the increased need for long-term capital spending linked to the energy transition will drive rates higher at the long-end. In the U.S., we still think that markets are not fully pricing the uncertainty around the pace of fed cuts, which is why we still have 10-year Treasury yields ending the year at four percent. |
| The Regional Banking Crisis May Be With Us for a Long Time | The Fed has ring-fenced banks’ losses on risk-free paper, but one third of small banks’ assets are CRE loans. Deposit flight is also still an issue. As such, we think that more regional banks could come under pressure if we are right that the Fed does not cut rates in the near term. |
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