Published on September 30, 2022

In this video, The Great Normalization: Managing Equities in a Highly Fluid Market, Larry Cordisco answers the question: “What is normal?” in equity markets and the economy.


Larry Cordisco: Let's just start with a very quick backdrop and these first couple bullets really are level-setting. They're not anything that anyone doesn't already know. This was one of the most dramatic recessions and dramatic recoveries - sharp, you could say - but I also could use the word dramatic, that we've ever experienced.

There were significant demand and supply shocks, and that really became sort of rooted in the definition of whether inflation was transitory or not. We're going to discuss that a little bit more in detail. But what we're working through now is the normalization process. Really, that last bullet is what I want people to think about going forward. Because what is normal? It may not be what we all became very accustomed to after the Great Financial Crisis where the economy was of a lower growth rate and inflation was on the lower end of history.

Actually, we may be normalizing to a period that looks more like the 1990s and early 2000s where you had inflation between 3 and 4% quite frequently, but also a lot of growth in the real economy. So basically, we want to keep people's minds open to the idea the future may rhyme with the past, but not the recent past. So just touching on just where we are with the market. If you had told me going into Covid that the world would shut down and we'd have a 30% drop in GDP, supply chains would end up being disrupted for a number of years, and we wouldn't be traveling as much and you said we're going to basically accelerate the market, the equity gains on the heels of a 13-year bull market, I don't think I would've taken that bet, but that's certainly what happened.

In retrospect, what we can see was really fueling that last rise in the market was a combination of an earnings explosion. The S&P earnings grew by 45% or so over a three-year period, which is pretty remarkable. That was a function of, or has been a function of all this demand that we're seeing and part of itis stimulus checks, part of it was people nesting, and basically zero rates and a lot of Fed liquidity, right? These are all the contributing factors and that's unwinding now. So if you look at the long-term trend in the market, it really does beg this question of are we going to return to that trend line?

We certainly should, given that rates are rising. Do we do that in a more dramatic fashion, which would be a further correction from here, or do we digest basically the market and let time catch up to earnings? This is really one of the big debates in the market. Nobody knows the answer to this question. But I think this is sort of where we lie in the grand scheme of the market.

All of this has unleashed the word of the year, if you all seen word bubbles, of how often a word is mentioned, "inflation," I think, gets the biggest bubble, the biggest representation for 2022. The year started out and actually 2021 ended with this whole debate of a transitory versus structural. It's been very hard to tease the two apart. A lot of it has to do with there really are transitory factors hitting inflation, whether it's supply chain disruptions, shipping costs with containers being short of supply or in the wrong place, bad allocation of labor and resources. All of this has really created a problem with getting goods to market at the same time that demand has remained not only quite strong, but well above trend.

So those are the transitory factors, but we're going to go through a couple slides here where, if you think about the trend of globalization ending and then a couple other very big markets that we're tracking and specific to the United States as well, there's a pretty strong argument for more structural inflation. So when you look at this long arc here, and this goes back to 2000, but you can extend this chart all the way to the '90s and it looks very similar. 2% inflation for a long time was the floor. Then you can see after the Great Financial Crisis, it became the ceiling.

We couldn't quite get above it, but now that we're above it, boy, are we above it! The big trick is to get this number back to that 2% or so range. I think that's going to be difficult, but if we can get to 2 to 3, 2 to 4, I think people will be pretty satisfied with that. But again, you think of the long arc. I think that 2 to 3% inflation is probably going to be more the normal going forward, as opposed to what we saw after 2008.

That brings us to really what the Fed is trying to accomplish here. I don't get too into the Fed speak, but I did catch Jerome Powell's speech at Jackson Hole. Two things caught my attention that made me want to look and see what was going on in the '60s and '70s. He mentioned the 1970s a couple times in his speech and he mentioned Paul Volcker. And I thought, "Well, if you wanted to get a sense for what's motivating this entity, the Fed, to be doing what they're doing, let's look at the 1970s." This is really, I think, one of the more fascinating economic case studies that you'll find.

I mean, certainly we know there was inflation. I think the thing that's not fully appreciated, at least not by me until recently, was that inflation were three different independent peaks. Both of those peaks saw acceleration when GDP was accelerating. This is exactly I think what the Fed's trying to get in front of. When we get to an economic recovery, they do not want the inflation genie to be released out of the bottle, and then we end up with an inflation floor in the early '70s that was just under 4%, and in the mid to late '70s right around 5 or 6% until it finally peaked in the teens. That's what the Fed's trying to get ahead of.

So we've been in the camp that just peaking inflation is not enough. It's not a satisfactory condition to get more bullish on equities. We really want to see proof that the inflation level is sustainably going lower, and we're not there yet, right? That was something that the market over the last month has sort of had a bit of a reawakening on in terms of where the risks are in the economy and with inflation.

These next couple slides will go pretty quickly, but these hit on why we think there is more structural inflation than transitory. We look at a couple big markets. The first one is labor participation. This is just labor participation. Demographics are also negative. We're not growing our population very much right now. The people who are working age in the population, there's fewer of them working. It's not just Covid. You can see, obviously, we dropped quite a bit with Covid. But it's a long term-trend of labor participation declining.

So what that means is reshoring and onshoring and investments in infrastructure and alternative energy, all that's going to demand labor. We suspect that the wage growth will stay sticky to the upside here going forward, especially in these industries that are most on the receiving end of demand for some of those things I just talked about.

Energy prices. Energy's notoriously volatile, right? The crude price is notoriously volatile. So this is not meant to suggest that if we go into recession energy prices won't go down. But what I do want people to think about is in a normal economy with a growing demand, we have not increased global production of oil since... We're basically producing the same number of barrels a day since 2013 and '14. Demand has increased. We used to have two to three million barrels of slack in the system. Now there's about one million barrels a day of slack, and that's contributed to higher oil prices.

A big reason behind this is because of the volatility of oil prices, energy companies just don't want to invest as much money on production. They want to try to maximize the profits for what they're producing now. So we don't think this story changes very much going forward. The third market I'll touch on briefly here is housing. Another example of structural inflation. The U.S. population is 20% larger than it was in the late '90s, early 2000s. It also has a higher mix of people and household forming ages, the current Millennials and older Gen Z folks are much larger as a percentage of the population than the Gen Xers were back in this day, yet we're building the same number of houses we were back then.

If you think about how the Fed tracks inflation with owner's equivalent rent, it's basically even if we have a rollover in market prices, just the fact that that there's not as many homes to rent is going to be very sticky. It's going to make rents very sticky to the upside as these cohorts of the population age and get into family forming years. Rents, my point being, is what drives the inflation number that the Fed is tracking more than anything else.

So you have these three markets that are significant contributors to how the Fed measures inflation. All look very tight to us and all look to us like they could have significant price responses to strong demand in a good economy. As result of this, rates have moved fast. This is an example or this is a measurement of the two year Treasury rate and its rise, it's actually over the 12 month is the chart. So a year ago, what's the difference in Treasury rates versus one year ago? This, as you can see, is the fastest move in rates since the early '90s. It's also because inflation's moving faster than it has since a long time. That's since the early '80s.

It's the rate of this change that's been highly disruptive to financial markets. Not only that the rates are suddenly the two years suddenly close to 4%, which is pretty surprising to a lot of people, but it's the speed at which we've gotten there, which has been very disruptive to financial markets. If you look at the 10-year Treasury bond, this is I think one of the more interesting charts and kind of dovetails with the stock market chart I had at the beginning, we've had a 37-year bull market in bonds and that appears to have ended.

We've broken out of this very well-defined long term channel. I'll point out that this is the first rate cycle during this entire period where we now have higher rates than what the previous cycle high was. So in 2018, we got as high as 3.25%. We're now at close to 3.5% on the 10-year. This is the first time that that higher high has happened in this entire cycle. It's a very big change to the overall environment. It's one of the reasons we're staying very tight on duration and also carrying a little more cash than we typically do across accounts.

So what does this all mean? The volatility is probably something we're going to have to live with. If you've heard us speak before, one of my favorite words for all this is "patience." I think it's going to be a process of absorbing higher rates over time, but the volatility is going to continue. We think the Fed will continue even if the economy continues to slow and that's something I think the market's now starting to key in on. Earnings numbers are probably a bit at risk and we're seeing a number of pre-announcements. Ford was yesterday, General Electric was I think last week. We've had a couple chemical companies.

It's been this weird combination of just on the margin, you have FedEx, just on the margin, a little bit less demand in some cases, but a lot higher supply chain costs and inflationary pressures that these companies can no longer push forward. If you've heard us speak over the years, you've heard us say or really emphasized pricing power with our investments. Where we are here in this cycle, that issue, will be a real differentiator. We're going to find out who has pricing power and who doesn't have pricing power. I think it's going to be something that really matters going forward.

Then of course I think that's going to be a very important part of an investment return profile going forward, especially if we have this gradual rising of rates over the next couple economic cycles, which ties into that last bullet point that the new normal may look a lot different than what we got used to the last couple years, the last 15 years.

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