IN THIS ISSUE
During the post-Great Financial Crisis (GFC) expansion, Fed officials often talked about not waiting to see the "whites of inflation's eyes" before raising interest rates, citing their belief that monetary policy acted with long and variable lags and seeking to avoid runaway inflation. This appears to have been self-defeating as inflation ran persistently below the Fed's 2.0% target for most of the expansion, and inflation expectations trended lower in acknowledgement of the forward-looking hawkish tilt. The new Averaging Inflation Targeting (AIT) framework's goal is to correct this mistake by acknowledging the important role inflation expectations play, whereby it "seeks to achieve inflation that averages 2% over time". For investors, this means that the Fed will now not only wait to see the "whites of inflation's eyes," it will likely put on its best poker face and stay the course, keeping policy rates pinned near zero. This is a positive backdrop for equity investors, as higher inflation will boost nominal gross domestic product (GDP) growth with flowthrough to corporate revenues and profits. Investors should maintain a tactical reflationary bias as well, in our view, in anticipation of the Fed letting inflation run hot. Below we provide some commentary around the outlook for inflation in 2021 and the potential for the Fed to hit its target.
Relative to the post-GFC expansion, the strength of this economic recovery and the starting point for both cyclical and structural inflation gives the Fed a fighting chance to reach the 2.0% inflation target it has pursued mostly unsuccessfully since 2012. Cyclically, the San Francisco Fed's Cyclical Core Personal Consumption Expenditures (PCE) Inflation, for example, was already running 2.9% year-over-year in August, compared with just 0.4% in June 2010, one year after the end of the GFC recession. And the fraction of items within PCE inflation that experienced price declines was smaller during this recession versus the GFC, suggesting there is a smaller hole to dig out of. Survey measures of prices, like the Institute for Supply Management (ISM) Manufacturing Index, and the Economic Cycle Research Institute's leading indicator for inflation, suggest there is upside to cyclical prices.
A key difference during this expansion was a more robust reflationary policy response, which is set to continue. Both monetary and fiscal stimulus were more efficiently administered and more aggressive. On the fiscal side, given the uncertainty around the nature of the coronavirus at the time, the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") was conservatively calibrated and ended up more than covering the coronavirus-induced decline in personal income. As a bonus, the labor market has recovered faster than most expected, and private sector wages and salaries income is already back to at least 96% of pre-coronavirus levels and rising. Over the two weeks through October 9, continuing claims for unemployment insurance fell by over 2.2 million, squashing rhetoric that the jobs recovery is slowing. When you add in government transfers, personal income is generally well above what it would have been sans coronavirus. We could see more fiscal stimulus this year or next, which would further support the reflationary effort.
The faster labor market recovery combined with the fiscal stimulus raises the prospect of higher wages. The National Federation of Independent Business (NFIB) Survey showed that the net percentage of firms planning to raise worker compensation in the next three months has risen from 7% in April to 16% in September. The same survey is registering solid readings in job openings and plans to increase employment, suggesting the labor market is tightening. While the unemployment rate remains historically high, the pace of tightening is unprecedented, and if it continues, will be supportive of broader cyclical price inflation, particularly if the Fed can raise inflation expectations at the same time wage growth is picking up.
Labor market conditions will take a backseat to inflation expectations, though. Fed Chair Powell noted in his Semiannual Monetary Policy Report to the Congress before the Senate Committee on Banking, Housing and Urban Affairs in May 2019 that "inflation expectations are now the most important driver of actual inflation." The link between the labor market and inflation may be weaker than it used to be because low inflation is well-entrenched in inflation expectations. Could the Fed's AIT fix this? If the Fed stays the course and fiscal stimulus remains supportive, we think so. The Fed will not pre-emptively raise rates to contain potential inflation, but it will put on a good poker face. And the Fed is leading the global monetary policy initiative in this direction, which could also help reinforce domestic conditions. A weaker dollar should also help domestic reflationary efforts.
Cyclical inflation could get a boost from the credit cycle as well. As we have noted in the past, household leverage (as measured by the subcomponents of the Chicago Fed's Financial Conditions Index) is relatively benign, leaving room for U.S. consumers to re-lever. Revolving credit has been contracting during the pandemic, but cyclically revolving credit acts more as a coincident than a leading indicator and should turn as the coronavirus fades and jobs continue to come back. And the housing market is booming, lifting home prices and home equity, which could act as a source of credit growth. Fed officials, including St. Louis Fed president James Bullard, have noted that the Fed may also welcome an inflationary shock that could act to boost cyclical inflation and reinforce inflation expectations.
Structurally, deflationary forces appear to be "less bad," but technologies' ability to unleash capacity across sectors is a formidable force for the Fed to try to overcome to boost inflation expectations. For example, globalization and technological change figure prominently in goods-sector inflation, which has been running below zero during the period since the Fed started targeting 2.0% inflation in 2012. With only one exception (in July 2011), the year-over-year PCE Price Index for Durable Goods has been below zero since 1995. The pandemic has rattled the cage, though, and the index was up 0.94% year-over-year in August. The main source of deflation in this sector is in technology goods like televisions, personal computers and software. Interestingly, the PCE for personal computers and tablets has been on a steady uptrend from its low of -38% yearover-year in January 1999 to -3% year-over-year in the August reading ("less bad"). The index touched above zero in June for the first time since 1979. The re-working of global supply chains with a national security focus may reinforce the trend away from deflation in some parts of the consumer technology space. Still, technological progress boosts productivity, which is booming in the U.S., and will act as a significant challenge for the Fed as it will keep a damper on inflation, but at the same time it will likely give the Fed even more reason to hold the line as advancements in artificial intelligence and other areas are moving fast. Without a sustainable pickup in inflation expectations it will be difficult for the Fed to keep inflation above 2.0% for a sustained period of time.
Putting all of this together, and considering the low base effects from the two-month recession earlier this year, inflation should run above 2.0% for at least a few months in the first half of next year, and the probability of inflation running above 2.5% has risen from near zero to 19%, according to the St. Louis Fed's Inflation Pressure gauge (Exhibit 1). There is cyclical upside in a number of the more volatile components of inflation like hotel rates if the pandemic allows for it. The effect of the housing boom on inflation will be difficult to gauge as home prices are going up and the owners' equivalent rent in PCE should also rise, but actual tenant-occupied rents are falling in some major cities and will act as a drag. Beyond the cyclical pickup in inflation, the medium-term path will be determined by expectations, and the Fed's actions will prove most important.
Exhibit 1: St. Louis Fed Measures Suggests Probability Inflation Runs Above 2.5% in the Next 12 Months Is Rising.
As mentioned, for investors higher nominal growth is good for revenue and earnings growth and will support equities. Additionally, a reflationary bias for investors has more upside because under the new framework the Fed will not react as hawkishly as it has in the past to inflationary shocks. Rising inflation expectations would put upward pressure on longer-dated yields even as the Fed holds the short end of the yield curve near zero. From a contrarian perspective, it also goes against the increasingly consensus view that the Fed is pushing on a string and bound to end up in a Japan-like scenario of persistently low inflation. The combination of the AIT framework, fiscal stimulus and a good poker face to rebuild credibility could prove this view wrong.
As we enter a period of heightened market volatility due to presidential election uncertainties, we urge investors to see the forest for the trees and look beyond the "world-is-coming-to-an-end" headlines. Yes, we expect a "seesaw" investment environment over the near term. We believe that investors should think long term and opportunistically leverage market pullbacks in the weeks ahead on Cybersecurity, Healthtech, Infrastructure and Platform economy (C.H.I.Ps). We explain below.
Cyberattacks have increased along with the spread of the coronavirus. Much like the coronavirus, cybercriminals have the potential to upend cities, states, companies and individuals. In fact, targeting technologies heavily relied upon by a remote and virtual world, nothing is off limits for hackers—hospitals, drug companies, schools nor banks. Lack of investment and security upgrades has left the healthcare sector and valuable patient data exposed. The healthcare sector commits only approximately 5% of its annual budgets toward cybersecurity—an amount less than half of other sectors and a woefully inadequate sum in today's virtual world according to Gartner Research. In the first half of this year, the Department of Health and Human Services reported a 50% increase in the number of healthcare-related cybersecurity breaches.
Brought on by the pandemic, the risks to online systems have increased with work pushed to remote locations, the widespread introduction of digital learning, and other general activity online. While most cybersecurity architectures were designed for a single company facility, the shutdowns and attendant shift into homes while accessing business systems has had huge implications for endpoint security. What all this means: We expect an accelerating pace of cybersecurity spending by companies and governments, with current spending expected to hit $147 billion this year; Gartner Research estimates spending will subsequently grow from 9% a year from 2021 to 2024. Finally, massive data creation is accelerating the transition to the cloud with cloud security one of the fastest growing segments, a near 33% compound annual growth rate out to 2024.
Manufacturing, advertising, transportation, agriculture, retail, finance and travel—there is hardly an industry that has not been touched—and/or torched—by the incessant advancement of technology. Pick virtually any sector of the economy, and there's a good chance it has been upended by chips and clicks, save one: the U.S. Healthcare industry.
Enter the coronavirus pandemic—one of the world's most debilitating healthcare crises in over a century. The coronavirus has hastened the merging of healthcare and technology, with the world now intensely focused on applying every available technological application and technique to the crisis.
Looking beyond the pandemic, a future filled with wearable devices, at-home testing apps, mobile messaging between doctors and patients, and a more proactive approach to healthcare may become the norm. The key to cost savings lies in machine learning algorithms that can process massive quantities of patient data tracked through smart health devices and detect abnormalities, alerting doctors in real time. Earlier detection and treatment can result in significant cost savings for the healthcare system. Note that the sickest 5% of the population consume 50% of total healthcare spending, and about a third of these "expensive patients" are those suffering from chronic conditions such as diabetes or stable heart failure.
Thus the pandemic has helped fuse science and technology. Technological capabilities and computational horsepower are fundamentally altering the largest sector of the U.S. economy—the $3.7 trillion healthcare industry. It's an affiliation we believe to be replete with opportunity around HealthTech—or the dominant leaders and players in medical technologies spaces as well as many leading pharmaceutical and biotech companies.
Yes, infrastructure, not in the way of roads, bridges, damns, but instead—infrastructure supporting 5G, solar and wind investments, and electric vehicles (EV).
The future of mobility is EV, but this transition will require both an investment and policy overhaul, much like California's recent commitment to phase out passenger vehicles with internal combustion engines by 2035. McKinsey & Company estimates 13 million chargers will be needed across the country, costing $11 billion in capital investment by 2030. Pile on the procurement of renewable power, energy management services, batteries, and a host of peripheral services and infrastructure, and plenty of capital spending is expected in the years ahead. We expect either administration—Biden or Trump—to spend on the infrastructure build-out of electrical vehicles. As a benchmark of future growth in this sector, only 2% of the U.S. car market is currently electric.
Per 5G, despite the hype, the inconvenient truth is that the U.S. is not yet fully equipped with the necessary infrastructure and complementary technologies for an orderly 5G rollout, and therefore the transformational potential of a fifth-generation network. While ultra-fast speeds over a low-latency network is where we are heading, a massive infrastructure effort is necessary in getting us there. The global 5G supply chain broadly consists of smartphone makers, semiconductor suppliers, component makers, telecommunication equipment vendors and operators supported by more fiber optic cables, towers, data centers and small cells. To get an idea of the build-out and in support of 5G networks and growing data demands, the addition of 800,000 small cells is needed to be installed by 2026, according to S&P Global Market Intelligence.
Finally, the current pipeline of wind and solar projects is large, but, as renewable energy increasingly goes mainstream, even greater amounts of capital will be spent on the renewable grid itself, as well as distribution and storage capabilities/facilities. In May, the U.S. Department of the Interior approved the eighth-largest solar power facility in the world, expected to power 260,000 homes in the Las Vegas area. Bloomberg predicts in five years' time it will be more expensive to operate an existing coal or natural gas power plant than a new solar or wind farm. In fact, last week the International Energy Agency said solar is starting to take over from coal as the cheapest form of electricity— meaning, the EV-olution is underway, which we expect will gain even more traction under a Biden administration.
The creation of digital communities and marketplaces has allowed more streaming, gaming, learning, shopping online—all especially important to pandemic times. This includes nine out of the 10 largest tech companies by market value right now, while, according to McKinsey & Company, "By 2025, some $60 trillion in annual revenue could be redistributed across the economy—one-third of that year's total. This dynamic is playing out in the high tech, media and telecom sector, where tech giants have built platforms on which entire ecosystems run."
Some platform companies have already benefited from the pandemic, like the e-Commerce and brick-and-mortar retail tradeoff, pulling forward years of online growth. Retail sales at nonstore retailers (inclusive of the online segment) proved resilient for the month of September, up 24% from a year earlier. The growth of platform companies and marketplaces has gone as far as enabling trade for small and medium-sized businesses through the platform's supply chains in reaching end users.
Now and on the other side of the election and pandemic, we see the platform economy as a clear example of the "big get bigger" not only valuation-wise, but also in the growing importance of the digital economy as a driver of growth. Over the past decade, the socalled digital economy has not only been a bigger contributor to U.S. growth but it has also expanded at a growth rate triple the overall economy, according to the Bureau of Economic Analysis. And there is more upside down the road considering that over 2.4 billion people worldwide have never logged on to the internet; e-Commerce sales in the U.S. represent under 20% of total sales, implying more upside growth; and the Internet of Things is still in its infancy but will be enabled over the next decade, providing even more earnings potential for platform leaders.
Cybersecurity spending is set to accelerate as more of the global economy goes digital. The premium on public health has fused two of the economy's largest sectors: healthcare and technology. Constructing the infrastructure of the 21st century entails billions of dollars in capital investment in 5G, renewable energies and electrical vehicles. And the future of the U.S. economy (and global economy) increasingly rests on the platform economy, with more and more platform companies disrupting and controlling an increasing share of aggregate output.
Against this backdrop, we are constructive for the medium- and longer-term on the C.H.I.Ps, and view periods of market volatility and pullbacks as favorable entry points into some of the fastest-growing and most dynamic sectors of the U.S. economy.
The trough in corporate earnings growth may be behind us, and certain valuation multiples appear primed to compress a bit as third-quarter (Q3) profits pick up and future expectations gather steam. The pace of economic recovery in the U.S. has helped corporate sales and profitability to a level unexpected by many, and as management guidance turns increasingly positive toward the future so too have analyst projections.
On June 26, the consensus earnings per share (EPS) estimate for the S&P 500 this year had dropped to $127, representing a 22.2% year-over-year (YoY) decline, according to FactSet. This contrasts with consensus expectations of $178 at the beginning of the year. Having endured the historic economic fallout from the pandemic, yearly profits are still expected to contract; however, the pace has declined, with current estimates tallying $134 EPS. Q3 is anticipated to be a pivot quarter, in which the pace of profit deterioration would decline, and, thus far, this has proven accurate. Of the 121 companies to have reported, YoY profit growth reported is -14.3% as opposed to -31.6% in Q2. The lagging sectors remain Consumer Discretionary, Industrials and Energy, while Technology, Staples and Healthcare are actually expected to post positive full-year earnings growth. Importantly, future expectations are also improving, with 295 companies having positive one-month upward revision momentum as opposed to just 104 downward revisions.
We continue to believe that relative valuation measures, such as the Equity Risk Premium, remain more relevant given the historically low rate environment. However, earningsbased valuation measures are also becoming more attractive as current and expected profits increase. Since August 28, the S&P 500 multiple on expected 2020 earnings has decreased by 1x. The process of earnings growing into multiples has started, and this should ultimately create a stronger foundation for the equity markets in 2021 and beyond as the economic normalizes post the arrival of a vaccine.
Exhibit 3: As the Economic Recovery Picked Up in the Summer, So Did Company Expectations.