“If all the economists in the world were laid end to end, it wouldn't be a bad thing.”
—Peter Lynch, One of the greatest investors of all time.
The number of economists predicting a US recession in 2023 is at an all-time high. Earlier the economists were predicting a recession in 2022 itself. Now that a 2022 recession looks unlikely, the bets are on a 2023 recession. The more hawkish the Fed’s tone gets, the shriller the economists’ predictions of a recession. But ironically, the Fed becomes more hawkish as the economy shows more growth and resilience. In short, the stronger the economic data comes in, the higher the predictions of a recession in 2023.
And yes, it is a possibility. As the Fed increases the interest rates and shrinks the balance sheet, the availability of money decreases and the cost of capital increases. This could reduce investments and borrowing-led consumption, which could reduce the GDP growth rates initially. If the Fed overdoes it then it could lead to a recession.
As Moody’s Chief Economist Mark Zandi says, the US risks talking itself into a recession. While qualitatively the above looks possible, the scientific investor should always look at hard, quantitative data first. And the Fed also looks at hard economic data before deciding on a rate increase and its quantum. Since the expectations of a recession are primarily based on Fed actions, a scientific approach would be quite helpful.
The US GDP growth
According to the Bureau of Economic Analysis (BEA), the US GDP in 2022 is nearly $25 trillion. The Congressional Budget Office (CBO) forecasts that the US GDP in 2032 will be $37 trillion. While that works out to a modest growth rate of 4 percent CAGR, one should keep in mind that that is an increase of $12 trillion in 10 years. On average, each year $1.2 trillion of GDP is getting created. This is the result of new revenues and earnings for companies. That represents a huge opportunity. If one takes a few steps back to look at the big picture, then one can see that there is huge absolute growth in the long term.
Coming to the current data, the 2022 US Nominal GDP growth is expected to be in the range of 6 percent-7 percent based on the Fed dot plot (FOMC projections June 2022). The BEA reports the PCE (personal consumption expenditure) inflation for July 2022 at 6.3 percent and the Core PCE inflation (ex-food and energy) at 4.6 percent. The Fed dot plot forecasts the Core PCE inflation for 2022 at 4.3 percent.
In CBO’s projections, elevated inflation initially persists in 2022 because of the combination of strong demand and restrained supply in the markets for goods, services, and labour. Inflation then subsides as supply disruptions dissipate, energy prices decline, and less accommodative monetary policy takes hold, it said.
In CBO’s projections, the price index for personal consumption expenditures would increase by 4.0 percent in 2022.
While the inflation remains above the Fed’s target of 2 percent, it is likely to get tamed, and, most likely, has already peaked. Also, note that even the CBO acknowledges that the inflation is due to supply disruptions and as they dissipate, it anticipates a reduction in inflation. As we have maintained consistently, we are in a deflationary world with huge production capacities. When the supply chains normalise the inflation is likely to turn into deflation. The current inflation is less about “money printing” than supply chain disruptions. One indicator is the gold prices. If money printing was the issue, then gold prices should have gone up. Right now the gold prices are nearly the same level as just before the pandemic.
The next important data is the unemployment levels. According to the Bureau of Labor Statistics (BLS), the unemployment level was 3.7 percent at the end of August 2022. The number of unemployed was nearly 6 million while job openings were more than 11 million, or nearly twice the number of unemployed.
Anyone looking at the above data could infer that the economy is doing extremely well and is likely to continue doing well.
According to the NBER (National Bureau of Economic Research) the typical recession lasts an average of 10 months, ranging from 6 months to 12 months. Thus, even if a recession came in 2023 or 2024, it is likely to end in a few quarters. Also, keep in mind that by the time the recession comes, two things will happen. The Fed is likely to cut rates or start sounding extremely dovish and the market is likely to start looking beyond the recession to future growth. Of course, the scientific investor would conclude that a 10-month recession would have a very small impact on the intrinsic value of a company. (The intrinsic value of a company is based on the projected free cash flows of companies in perpetuity.)
Coming to valuations, the S&P 500, representing the large caps, is available at a projected PE of nearly 18. This translates to an earnings yield of 5.6 percent. The S&P 600, representing the small caps, is available at a projected PE of nearly 12. This translates into an earnings yield of 8 percent.
The expected returns can be estimated once the earnings yield is reduced by the expected capital investments. The remaining yield is available for distribution to shareholders. Besides the free cash flow yield, the shareholders also get returns from the expected growth in the company’s revenues, earnings and free cash flow. This growth for most companies ranges from 4 percent to 10 percent in the large caps, which have a higher proportion of international revenues, and 4 percent to 7 percent in the small caps, which have mostly domestic revenues.
Compare the earnings yields and growth rates with the Fed fund’s rate which is at 2.25 percent to 2.5 percent and expected to peak at around 4 percent.
Omni Supreme US, a US Flexicap portfolio designed using our internal research, currently sports a price-to-cash flow of 12.3 and a cash flow yield of 8 percent. This shows that if one were selective, one could create an attractive portfolio from a valuation point of view. While the growth for traditional sector companies ranges from 4 percent-10 percent, many technology stocks and innovative companies from traditional sectors are able to grow in double digits.
It is clear that the US economy is doing well and is likely to continue doing well. Even if a recession strikes, it is neither likely to slow down the economy in its secular growth nor put a dent in the intrinsic value of the companies. Currently, the market is attractively priced. A long-term investor has a great opportunity.(The writer is CEO and Chief Investment Strategist, OmniScience Capital)