Winter is Coming (Again)

Shortly after we formed Fire Capital in 2019, we published market commentary titled “Winter is Coming.” The commentary’s thesis was that caution was warranted based on evidence that economic fundamentals were beginning to deteriorate after a historically long bull market coinciding with the Fed beginning to unwind a decade of accommodative policy. At the time, valuations were quite high meaning there was further to fall if something unexpected happened. These factors led us to reduce portfolio risk and hedge accordingly.

Of course, we could not have predicted the global pandemic, but our perspective and approach gave us a head start on adjusting client portfolios as COVID-19 began its global spread at the start of 2020 until the financial markets finally responded in March 2020. We’ll never know for sure what would have happened without the pandemic, but we firmly believe there are times to heed caution because the margin for error shrinks considerably. Now, we find ourselves again at a time to be cautious and risk aware. Our mindset is to persevere through what we expect to be a challenging 12-18 months.

This Time IS Different

We are very careful, and at times dismissive, when we hear market pundits state, “this time is different”. That is because history may not always repeat itself, but when it comes to investing it does tend to rhyme. At the same time, it would be a rookie mistake to allow the markets or historical analogs to become the basis of how we feel in the moment about the economy or regarding potential future returns.

Throughout my career I’ve relied on market fundamentals to guide important investment decisions. Since 2008, there have been several times when the markets dislocated from underlying economic fundamentals. A couple high profile examples that rattled markets include the Brexit announcement(2016) and the Taper Tantrum (2013). In actuality, from 2008 to pre-pandemic, there were seven instances when the markets corrected with an average drawdown of about -21 percent. All these events forced investors to question whether the bull market was over. However, there are a few stark differences between now and then. In past corrections: 1) fundamentals were mostly positive, 2) inflation was low, and 3) the Fed was historically accommodative to stimulate economic growth. Clearly the narrative has changed and as such, this time is different.

The Trend isn’t Favorable

There are many factors to consider when evaluating the health of the broad economy. However, the health of the consumer and corporations generally stand above the rest. Inputs such as inflation, wages, and interest rates affect both. While we admit the underlying data remains “mixed,” the trend based on our models is less than favorable.

Following the pandemic, the pent-up demand story has seemingly come to fruition. Spending on services and experiences has risen dramatically. Unfortunately, the combination of inflation and rising rates likely makes this phenomenon short lived. In other words, the consumer may not have the ability to spend at the current pace going forward. Consumer confidence and U.S. real consumer spending has dropped considerably since the beginning of the year, as have household saving rates. Alternatively, credit card spending is on the rise. This has contributed to a notable slowdown in spending on goods and big-ticket purchases such as housing and automobiles. Prices remain elevated but it’s a matter of time until they adjust to reality. With that said, the long-term outlook for single family home prices and cars remains very bright.

U.S. businesses are also beginning to show signs of weakness. Important economic indicators such as the ISM Manufacturing Index (PMI),particularly the new orders component, are beginning to flash recession. The recently released Conference Board Measure of CEO Confidence tells a similar story as it declined for the fifth consecutive quarter and showed 81 percent of CEOs believe we’re moving to a recession (albeit a short and shallow recession). CEO confidence is important because it is an indicator of a company’s potential willingness to spend as well as to hire (or fire). Given rising input costs and slowing profits, the continued fall in CEO confidence is not surprising. While S&P 500 earnings have surprised to the upside, expectations have fallen through 2022 and 2023. Expectations probably need to fall further. Rising costs and eroding consumer purchasing power point to shrinking profit margins. Given the impact of margins on stock prices, protecting margins is of great importance. For publicly traded companies, these stock prices are often closely tied to executive compensation and when corporate profits fall, layoffs usually follow as compensation costs are estimated to be about two-thirds of overall corporate costs.

Structural Shifts Muddying the Waters

Investing is, and always will be, a blend of art and science. In recent years, with the increased availability of data and analytics technology, the art of investing has taken a back seat to the science. While data is of course valuable, it can also give decision makers false confidence as they attempt to predict the future. As data trends have been particularly messy since the onset of the pandemic, this is especially true now.

However, even if the data wasn’t messy, it is important to consider how much it’s worth if the world has fundamentally changed. For most of 2021, “paradigm shift” was a trending phrase on Google Search. This phrase was tied to the post-pandemic world that would incorporate the metaverse, work-from-home, and the Great Migration. In addition to these new profoundly influential realities, there are also other material shifts that are affecting the global economy.

Take for example the global energy crisis that has fueled inflationary concerns across the world. Pandemic era lockdowns led to the abrupt stop of the global economy, ultimately causing oil demand to fall off a cliff. The lifting of these lockdowns had the opposite effect, generating a surge in oil demand. This demand-supply shock combined with the energy supply disruption related to the Russia-Ukraine war as well as a decade of underinvestment in the industry led to rapidly rising oil prices. As a former energy analyst, I can attest to the fact that oil production is complex and capital intensive. New projects require substantial capital, skilled human labor, and can take years to bring online. U.S. energy producers also face considerably challenges. After years of falling oil prices and paltry profitability, oil executives need to decide if investing billions of dollars in new oil production is worth the risk. In the past, in efforts to drive U.S. energy companies out of business, OPEC initiated a strategy to flood the world with oil. The wounds are still fresh from this fallout and who’s to say that won’t happen again. This is just one reason to believe oil prices could remain structural higher for longer.

The de-globalization movement is a separate but related structural issue. Following the UK’s decision to leave the European Union, nationalistic policy seemingly began to regain prominence. This trend carried over to Trump Era foreign policy as tariffs and immigration once again became front and center. Today the world is faced with numerous supply chains risks. Semiconductors can be viewed as the posterchild of such risks, with over 90 percent of the worlds advanced semiconductors supplied from Taiwan. In the wake of growing tensions with China, the U.S. has responded to supply chain risks with the bipartisan CHIPS bill, which subsidizes domestic semiconductor manufacturing. Onshoring of manufacturing is not a new theme but the trend is clearly intact.

For some time now, Economist Nancy Lazar has been calling Middle America the next emerging market. Across a wide range of industries, government policy continues towards making America a more competitive place to manufacture. In theory, this all sounds like great news. However, in the short-term we wonder where all the workers required to fulfill onshoring demands will come from. If middle American wages and economic activity accelerates, this will put upward pressure on inflation. In fact, one could conclude that inflation could remain structurally higher than the Fed’s two percent inflation target for sometime. However, it should be noted that prior to the establishment of the two percent target in 2012, three percent inflation was considered normal. Interestingly, while the paradigm shift is still happening in real time, we’re not sure if markets have yet to fully appreciate the implications.

This Isn’t the 70’s Show

Despite inflation being the primary focus in 2022, inflation is nowhere near what it was in the 70’s and early 80’s. If it was, the Fed could dust off ex-Fed Chair Paul Volker’s playbook and “fix” the inflation problem by aggressively hiking rates to drive the economy into a severe recession. It would be painful, but also somewhat swift. However, one could argue inflation is even worse than in the 70’s, but in a different way.

Because the world is significantly more complex, today’s problems are more complicated. The fragility and importance of global supply chains, the presence a U.S. and China bipolarity, and an extreme political environment makes it so. There’s also the emerging post-pandemic world to contend with. Frankly, it’s impossible to know how much excess inflation is tied to supply chain issues, excess demand, or structural shifts in the way people live and work. Without a deep measurable understanding of what the main issues are, the chances for policy errors are higher than most realize. As a result, the “peak inflation” narrative is just noise.

Aside from the well documented supply-demand imbalance and our concerns around structural issues, a tight labor market makes it challenging for the Fed to attack inflation with a well-defined plan.  In July, there were still two job openings for every unemployed worker seeking employment. Since 2020, a lack of workers has forced employers to continuously raise wages. In August, average hourly earnings, a measure for wage growth in the U.S., increased 5.18% year-over-year. The unbalanced labor market has also contributed to the stickiness of high inflation, but at some point, that will reverse. The Fed will make sure of that. As Fed Chair Powell said, “[the] labor market is particularly strong, but it is clearly out of balance, with demand for workers substantially exceeding the supply of available workers…there will likely be some softening of labor market conditions.”

Valuations Remain Elevated

As many of our clients have heard me say, high valuations equate to heightened risk because there is further to fall. Using the S&P500 as a proxy, valuation multiples are close to 10-year averages. However, the past ten years represented a different regime – one that was characterized by ultra-low interest rates and low inflation. If inflation proves to be sticky, current valuations are still too high.

During a recession, including the Great Financial Crisis, on average earnings per share decline approximately -24 percent. If valuations are indeed high, and earnings fall, the only outcome is lower stock prices. With the Fed actively working to slow growth via interest rate hikes, it’s difficult to rationalize a more positive outcome. Keep in mind that the Fed only began to increase interest rates in March of 2022. The effects of interest rate increase are not instant, they take time to percolate through the economy to achieve the desired result.

Despite the U.S. economy’s resilience thus far, other major economies, such as Europe and China, are in a much worse position. Given the fragility of the global economy, small missteps are magnified in terms of the impact they could have on the financial markets. Unpredictable events such as a broadening of the Russia-Ukraine war and increased tensions related to Taiwan would undoubtedly lead to further downside.

Prepare for the Coming Recession

If we can characterize some of our more optimistic peers as wearing rosed colored glasses, right now we’re wearing dark tinted aviators. According to the Financial Times, since the 1950’s, every time inflation has exceeded four percent and unemployment has fallen below five percent, the U.S. economy has tipped into a recession within two years. Given current market conditions, a no recession scenario would be an outlier. While our base case is not a terribly bad recession, the risks remain skewed to the downside so portfolios must be positioned accordingly.  

As fiduciaries of client assets, our job is to position portfolios to achieve favorable outcomes over the long run. Make no mistake. Adjusting investment portfolios properly due to uncertain short-term expectations around the markets or economy is never an easy task. For this reason, many seasoned investors don’t even try and stick to their long-term investment strategies. We generally agree with this mindset but there are times when the probability of an economic slowdown rises enough where risk-reward is impossible to ignore. As we continue to persevere through one of the most challenging investment environments in years, if not decades, we can’t help but think that winter is coming once again.


The information in this report was prepared by Fire Capital Management. Any views, ideas or forecasts expressed in this report are solely the opinion of Fire Capital Management, unless specifically stated otherwise. The information, data, and statements of fact as of the date of this report are for general purposes only and are believed to be accurate from reliable sources, but no representation or guarantee is made as to their completeness or accuracy. Market conditions can change very quickly. Fire Capital Management reserves the right to alter opinions and/or forecasts as of the date of this report without notice.

All investments involve risk and possible loss of principal. There is no assurance that any intended results and/or hypothetical projections will be achieved or that any forecasts expressed will be realized. The information in this report does guarantee future performance of any security, product, or market. Fire Capital Management does not accept any liability for any loss arising from the use of information or opinions stated in this report.

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Michael J. Firestone, CFA

Michael is the founder of Fire Capital Management.

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