Some market observers see us on the edge of recession. They feel it in stock prices but point to triggers such as an overactive U.S. Federal Reserve (Fed) seeking to put the brakes on inflation, war and commodity-related chaos in and beyond Ukraine, and persistent supply chain interruptions that’ve repeatedly slowed the post-COVID-19 recovery.
But when we look at U.S. stocks, battered though they are into bear and near-bear territory depending on which index we observe, we try to understand them in relation to economic fundamentals. Today, we see several signals of economic strength, some of which come from the consumer while others stem from the resiliency of U.S. businesses. When we pair these observations with our comprehensive analysis of stock fundamentals, we have reason to be constructive on many segments of the U.S. market. Even after we’ve refreshed our range of values analysis—and sharpened our pencils on bear and worst-case scenario changes—there has been limited change to our estimation of values overall.
The U.S. consumer continues to spend
The first signal of economic strength rests with the U.S. consumer. To be sure, different measures of consumer sentiment have fallen below levels last seen at the outset of the pandemic in March 2020. But in contrast to weakening sentiment, consumer spending has remained healthy throughout the pandemic and has continued to rise. This is particularly interesting to us as we believe what consumers do is arguably more telling than what they say in sentiment surveys.
The divergence between spending and sentiment is unsustainable, in our view, and we believe that with consumer sentiment at present lows, there’s much room for improvement. While consumers are struggling with inflation in many categories, we believe that over the coming year price increases should slow significantly as new supply comes available and the Fed raises rates to counteract inflation. While we believe we can expect the rate of spending growth to decelerate, overall spending should remain healthy as we return to more trend-level growth. In the meantime, consumers who managed to save during the pandemic are revealing surprising levels of pent-up demand.
Consumers’ aggregate debt remains manageable
A related reason for optimism can be found in the consumers’ strong balance sheet. Even through a period where inflation is putting pressure on real wages, we remain close to multidecade lows in terms of debt expense as a percentage of disposable income.
With the consumer balance sheet in good shape, we expect inflation may slow the pace of spending growth but isn’t likely to drive a large spending contraction. As U.S. consumers return to their prepandemic summer routines, we expect spending to remain supportive of GDP growth.
Business confidence and capital spending are looking up
Turning to business confidence, which is somewhat improved from pandemic lows, we believe there’s reason to anticipate improvement as well. A few of the hindrances to optimism here have included policy uncertainty, scarce labor availability, supply chain disruptions, and persistent inflation; however, we believe the recent surge in labor participation for key age groups and improving mobility in supply chains may help boost business confidence from current levels.
Perhaps most notably, capital spending plans remain at high levels and support our optimistic outlook. Corporations appear ready to make significant investments over the next several years to capitalize on the recovery, pent-up demand, and the need to improve or otherwise seek alternatives to global supply chains.
This planned capital deployment will be an important driver of economic and corporate earnings growth, which we believe will expand through 2022. While this is likely, in our view, to occur at a slower rate than in 2021, we believe that earnings in 2023 could potentially accelerate. Put another way, as we progress toward a post-COVID-19 new normal, businesses will find ample reasons to deploy capital with an eye toward maintaining or recapturing sustainable competitive advantages. We see this as very positive for the U.S. economy, and for the long-term value potential of U.S. equities.
Where we’re finding opportunities now
Against this backdrop, we’re finding opportunities to invest in compelling businesses across the value-growth spectrum. In many cases, the steep decline in stocks embeds assumptions of limited to zero revenue and earnings growth in the future. That makes little sense to us when we’re talking about the tech opportunities we see in software and semiconductors, to take two relevant examples. Some of these companies have been trading at previously unthinkable levels, in the neighborhood of 55 to 65 cents on the dollar in our range of values framework, where a dollar is equivalent to our base case for the stock’s value. In our opinion, that implies a significant upside to any scenario for normalization. Priced at these levels, stocks are discounting a recession that may or may not occur, and this creates compelling risk/reward conditions.
Defensive investments, from utilities to consumer staples and healthcare, have outperformed recently, but we don’t expect to find an infinite source of stability here, particularly when inflation is shown to have passed its peak and heads down toward a potentially more manageable ~3%. That’s something we expect to occur gradually, given today’s supply constraints in energy, agriculture, and metals, but it’s closer to our long-term base case for a global economy that we anticipate will experience onshoring trends.
As we focus on businesses that we believe can compound in value, are mispriced, and embed a margin of safety, we think the U.S. consumer will continue to mobilize and power the service economy. Although uncertainty and sentiment shocks have driven a wedge into growth and raised volatility to multi-year highs, these conditions have also created attractive opportunities that we’re prepared to seize across the value-growth and capitalization spectrum.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
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