Equity Risk Premium & New Market Leaders

KEY TAKEAWAYS:

• The economy needs to grow slower than the rate of productivity growth.  We’re skeptical that this can happen.
• Balance sheet roll-off – the big unknown and something to keep an eye on.
• Reintroduction of risk premium in areas of the market that have been suppressed or void of this completely is a very necessary step, but will be painful process to go through.

TRANSCRIPT

Brian Barish:

What we’re seeing pretty consistently, actually, is that if you had a sector or group of stocks that kind of over-earned or overgrew during the pandemic, odds are they’re now going to under-earn and under-grow. Netflix is a powerful example. It happened with Peloton. It happened with video games. But you’re also seeing the flip side of that; sectors that were under-earning or were under all kinds of extreme pressure are now over-earning because you had supply-side damage. You now have a smaller amount of capacity in the system and it’s leading to these blowouts in pricing.

Host:

Hello, and welcome to the latest episode of the QPD Podcast. On today’s show, we have Cambiar President Brian Barish back to discuss current market conditions. A lot has happened since Brian last joined our show just over three months ago. So we thought it would be great for him to come back and discuss some of the latest market developments and if his outlook for 2022 has changed. Brian, welcome back to the show.

Brian Barish:

Thank you, Jim.

Host:

Before we get into the specifics, how are you feeling about the markets these days? Like I said, a lot has happened just over really three months, both with the macro environment as well as the micro. So I’d love to get your thoughts as to where you sit today with respect to markets.

Brian Barish:

Sure. So a few things have happened that we expected. The first is that you have seen is that Fed moves towards renormalization. We can talk about that more. That the speculative class of stocks has really pancaked. It had pretty staggering losses there.

Secondly, we also discussed late last year, Omicron was a very quick surge and now we’ve moved to kind of the herd immunity phase or alternatively we’re just not going to keep doing this anymore in terms of these restrictive COVID type of policies.

So that’s a positive in my mind, but it is one that we expected. I think one thing that we weren’t totally clear on late last year was just how aggressive the Fed might need to be.

Host:

The last time you were here, you discussed at length about Fed policy. You’ve just kind of touched on it briefly here. So when you think about inflation, interest rates, this is pretty much the rage today as you’ve seen rates rise rapidly in the Fed starting to react and at least acknowledge that the inflation pressures are real. Can you discuss that at length how that might be impacting portfolios? Could it cause a recession? That’s been the topic of discussion as well.

Brian Barish:

Yeah. So there’s been a pretty loud chorus of people across the spectrum politically and in terms of their academic leanings with respect to economics, critical of the Fed like, “Guys, you should have started moving some time ago.” And we were part of that chorus and it’s very clear that the Fed has been off. I think that central tension going forward is you’ll hear the soft landing, hard landing, somewhat hard landing conversation.

So the Fed by having I think stepped off the ultra-accommodative policy too late, they do have a tough challenge on their hands. So we are at essentially 0% unemployment and there are people that are unemployed, but there are more job openings than there are unemployed people. So being unemployed is a 100% voluntary decision right now. We need to get back to there being some labor slack in Fed speak. It doesn’t have to be huge, but some labor slack. So how do you get there? Well, we have very little population growth in the US. So what you need to do is get the economy to a point where it grows more slowly than your rate of productivity growth.

So productivity growth is about one and a half, maybe 2% at best. So you would need to be growing at one or slower to get there. Can they really manage to do that to fly at that low of an altitude and not actually slip into an outright recession? People are understandably very skeptical of that. I’m understandably very skeptical about that. I do think when people throw around that R word, the recession word, people conjure up the last two recessions, which was COVID, which was awful. And the recession that was a consequence of the Global Financial Crisis of 2008, which was practically a depression.

I don’t think either of those are the right model. It might be more like what we had in the early 2000s, which was barely statistically a recession. I mean, GDP growth was like negative 0.1% a couple of quarters. That’s literally all you had, but we do need to create that labor slack, which means not all businesses are going to grow. Some are going to contract. Some are not going to make it. And that’s basically what we’re staring at.

The area that is I would say a big unknown, but generally something to be concerned about is balance sheet roll-off and we also talked about that late last year. It’s not clear how stimulative or contractionary balance sheet expansion or balance sheet shrinkage are. The Fed themselves, they don’t have a very good model of this. The Fed has talked about openly that they’re going to do 95 billion a month of balance sheet shrinkage. That’s much fast than they did back in 2017 and 2018, but the balance sheet’s much bigger so they need to go much faster, and obviously we have a bigger inflation problem.

I’ve read that based on various people’s modelings 95 billion of balance sheet shrinkage is about equal to 80 basis points on the Fed funds rate. So if you said that the Fed got to 2.25% and they’re doing balance sheet shrinkage of that size, that would be equal to something in the low threes as a functional matter. So the quirky thing about QE is what it winds up doing in the financial system. So what it winds up doing is it suppresses risk premiums. Besides maybe holding down long-term interest rates, which themselves contain risk, but if the Fed’s buying a lot of the long-term treasuries, then those risks are suppressed a bit, is it also suppresses risk premiums in corporate bonds, in mortgage-backed bonds, and in equity risk premiums.

So the framework that I’m using is that we are seeing a reintroduction of equity risk premiums in places where they haven’t been or where they’ve been very suppressed. And we’re also going to see an increase in risk premiums in other more easily measured areas like corporate bonds. That process, this a subtle point, but it’s a very important point. That reintroduction of risk premiums that process is very necessary, but we’ve been operating with suppressed risk premiums for most of the last 14 years and with a really kind of crazy period in the last two, that is going to be uncomfortable. That is going to hurt.

And I think when you look at the market today, so we’re doing this in the middle of April, various measures of market sentiment are terrible. They’re like as bad as they’ve been since 2009 when we were in a borderline depression and we’re not in anything resembling that economically. Maybe that’s why as people kind of know like this is going to happen, there’s no stopping it.

Don’t get too negative when you hear me say that because the market is forward-looking and multiples have come down and the market has begun the process of reintroducing these risk premiums. But I would also tell you that we’ve got a long ways to go and the Fed has barely done anything. There’s just kind of been a bull market and talking about doing things. And the next up is maybe going to hurt a bit more.

Host:

I think our audience would appreciate, does that mean that the suppression of risk premium, higher rates a shift in the types of equities that work? Is that what you’re referring to? I think there’s been a shift as far as what’s been working. We’ve seen deeper value, financials, energy starts to perform better. Is that what you’re referring to as far as this sentiment shifting towards those types of securities?

Brian Barish:

That’s definitely part of it. I’m going to focus on an area that we’re not really involved in materially, which is the disruptors. So there’s been a bull market in stocks that are disruption stocks, people have kind of fallen in love with them. A disruptor is a stock who doesn’t make a lot of money, maybe doesn’t make any money. So their cost of equity is sort of undefined if you will, but the market gives them a free pass. The market says, “We think this is so cool that this is going to be such a big thing that we’re just going to not ask you to make any money right now, because we think the pot of gold at the end of the rainbow is so big.”

Well, what if the market suddenly starts saying, “Actually, we’d kind of like to see you make money now”? That’s a big change if you’ve had no equity risk premium applied to you. So that’s one side of the ledger. Now, again, we don’t participate over there. Now there’s a flip side, which is the more physical economy, businesses whether you’re a bank or an energy producer or manufacturer of cars or widgets or whatever where no one was giving you an equity risk holiday in the first place. So there’s already been a risk premium in place. Now could that risk premium go higher? Yeah, but your downside is a lot less to begin with if there’s already been an equity risk premium in place.

So that all holds together. I think what you’re seeing at the moment is just because of a whole variety of factors that we may or may not be able to get into on this. Investors are kind of lunging at stuff and I think that will continue. So maybe it’s a bear market as the Fed gets into quantitative tightening as it’s called or alternatively maybe it’s a very rotational market, and you kind of don’t want to be a momentum guy. You want to sell the rips and buy the dips is the expression.

Host:

Oh, that’s great. That makes sense. Stepping outside of the US for a moment, you’ve recently written about a blog about the Ukraine conflict and discussed earlier about China’s about-face in regards to their ideology towards free markets. Have these risks been elevated recently, tempered or have they stayed the same for the most part?

Brian Barish:

Elevated would be the answer to that question. We wrote something and we at this point I think need to revise what we said about Ukraine, because we did not think Putin was going to go for a full-blown World War II-style land war. And that’s exactly what he’s done. If for the moment we assume that Russia remains a pariah state to the world as a result of this, it does have pretty meaningful supply chain implications. It does look to me like some of the critical supplies, so people have been worried about hydrocarbons and there’s a few other industrial metals that Russia’s a big supplier of, they will just go a different way.

So Russia will barter with China. Russia will barter with India. Russia will barter with a few other countries selling its cargos, probably at some kind of deep discount. We have been able to confirm that they are doing some of that now and using gold as a transaction currency. That looks like how things are going to go. So let me take like a large step backwards to like the 50,000 foot level. So I happened to start my professional career at the end of the 1980s right when the Berlin Wall fell and the Soviet Union was dissolved.

And there was a view at that time that there was an inevitable convergence of the world’s economic systems towards something that was a free market system that resembled the United States, because the US had won and these other systems were proven failures. And that thought that motivated a lot of international investing back then. And it really was viewed as inevitable. And you have to really kind of scan the memory banks a little bit here, but prior to that time, we spoke of the world as being a first world of the West and a handful of countries in Asia, a second Communist world that was in its own transactional bubble that didn’t really transact other than a barter arrangement with other countries.

And then you had a third world of less developed countries and it all seemed ridiculous because it was, but that’s how the world operated during the Cold War. And it looks like we’re actually going to go back to that. I can scarcely believe those words are coming out of my mouth because it’s ridiculous. It’s ridiculous. But that is kind of the direction that things are going. And one difference between Cold War I and Cold War II if that’s what we’re going into here at Cold War I, the USSR was the senior partner. China was kind of the junior partner. It’s the opposite now.

China is the senior partner. The USSR or Russia and friends is kind of the junior partner. But that is what it looks like for the time being. And I think you need to invest accordingly. Now we talked a lot about China in our last podcast and some previous ones, they took an ideological turn under Xi Jinping that has manifested in them really trying to restrict the profitability of its largest companies, as well as the degree of freedom that they can operate with. So as a shareholder, you do not enjoy normal shareholder rights at all.

There’s no sign that they’re backing off of that and that means that you’re at risk essentially in large companies. They’re now doing other things as it relates to COVID and COVID is now in the past tense I think in the Western world that are consistent with a totalitarian mindset. And it is, again, hard to believe I’m even saying this, but basically, we have vaccines that work and will keep you from dying or being severely sick.

China has some vaccines too, but they don’t work very well; rather than signing up for the Pfizer vaccine or the Moderna vaccine, they will do neither and instead of locking people in their homes where they’re starving and they will keep doing this it seems until they actually have a homegrown vaccine that they can give to their populations.

If this sounds insane, it’s because it is, but that is what they’re doing. And it looks like now the second world is this illiberal axis, it’s not a communist axis, but an illiberal axis of China, Russia, and a few other countries that are in Eurasia. How this evolves from here, Jim, I don’t know. But there’s an investible universe in Western Europe, in Australia, in Canada, in Japan and we will continue to try to operate sensibly within those confines.

Host:

Shifting back to US market. Now that companies are starting to report earnings, what are your thoughts broadly on the health of US companies? Ironically, we’re discussing this today when Netflix is down over 30%. We’ve seen some leadership really falter from some of the stocks that have pushed this market higher for the past 10 years. Just again with what’s going on recently with earnings, we’d appreciate your thoughts there.

Brian Barish:

Certainly. So there are some similarities to the end of the 1990s and the shift from what was an internet and digital economy mindset to a more physical economy and an industrial economy mindset that erupted right after Y2K happened. Back in the late 1990s, you had a lot of companies that were just flat-out speculative fluff and those pancaked and went down 80 or 90%. There were other companies that were blue-chip companies at the time. I’m thinking of like Cisco and Microsoft and Intel and America Online that were real companies.

But the issue was that the projections were just totally out of hand. They had experienced very rapid growth in the late 1990s as the internet boom happened. And then once you got to a certain point, which for the most part was the beginning of the year 2000, that growth tapered off sharply. They were real companies. Cisco was a real company, Intel was a real company that are very profitable to this day, but the projections were just very wrong.

Netflix is one of many companies that experienced hyper-normal growth during the pandemic. They pulled forward a lot of growth into 2020 and 2021 that would have happened at a much more gradual pace had we not all been stuck at home bored looking for something to do, and Netflix clearly offered you something to do. What you now have, it’s kind of reminiscent of network switching gear back in the early 2000s. You probably have too many streaming platforms. Not a lot of people are going to pay for five or six separate streaming subscriptions.

Actually, I saw a survey today that suggested that 45% of people are looking to cut the number of streaming subscriptions that they have. That’s a challenging formula. So it’s going to take a while to re-base and some of these subscription platforms are probably going to have to go away. I don’t think Netflix is going away, but it’s going to take a while to find what the equilibrium really is.

Host:

Obviously, we’re a little bit biased here with respect to being a fundamental bottom-up manager here at Cambiar. But when you talk about this shift in sentiment, all the volatility we’re experiencing, interest rates moving. What are your thoughts with respect to how active management can perform in that environment? It seems conducive to taking advantage of those types of opportunities.

Brian Barish:

That’s definitely how we’re looking at it, Jim. It could be a bear market or it could just be a rotational market and in a rotational market, if you’re momentum-oriented, you’re probably going to get grind to a pulp. If you’re in an index, you’re probably looking at going sideways at best for a while. The FAANGS or what used to be called the FAANGS, they’re something like 25 to 30% of the S&P 500 so you’re very concentrated in that group.

I think just having a price discipline, there’s a price at which I buy XYZ stock and it’s got a margin of safety and it’s got a big fat equity risk premium in it, I like that. And conversely, there’s a price where I say, “I don’t want to own this anymore. It’s just too expensive. Not my thing.” That is capable of working and that’s what we were dealing with for most of the decade of the 2000s until the housing bubble blew everything up. So I think there’s a good chance that we go back to that.

Host:

Great. Thanks, Brian. We appreciate you coming back so soon to discuss current market conditions and your outlook. Hopefully, these next three months can provide a little bit more stability and clarity for investors.

To our listeners out there, thank you for your support and please visit cambiar.com to learn more about the content we mentioned earlier in the show. 

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