Economic Insights with Barry Knapp
On Thursday, March 10th, 2022, we hosted economist and market strategist Barry Knapp of Ironsides Macroeconomics for an exclusive Zoom meeting for our clients. Barry has over four decades of experience in strategic investment management positions with major Wall Street financial companies. He is a frequent interview for the financial networks, and his deep insights are rooted in historical facts and the broader business cycle.
Sometimes it is best to begin with, the conclusion.
It can be scary or feel foolhardy, to invest during geopolitical events like those the world grapples with today. Barry’s approach focuses on analyzing the likely effects upon the U.S. economy. He concludes this is likely a good time to put money to work.
The correction experienced thus far in 2022 is an appropriate reset of stock valuations relative to prior periods of central bank policy pivots from accommodative to tightening. Barry sees virtuous and sustainable dynamics underway in the economy, which will benefit corporate earnings. Productivity gains are a vital underpinning to Barry’s thesis. He cites evidence of improving productivity resulting from:
- A rebuild of U.S. capital stock igniting a boom in corporate capital expenditures.
- Labor force dynamism where workers are much more fluid and arrive at a higher and better use of their skills.
- Broader adoption of the technology build-out.
These productivity drivers are natural outcomes of the secular trends of deglobalization and were accelerated, out of necessity, in response to the global pandemic.
The rebuilding of U.S. capital stock, current valuations, a broader North American trading block, and the investment in technology will manifest in high-profit margins, strong productivity growth, and economic growth.
Inflation and the Fed’s response
The pandemic was the antithesis of the financial crisis because it was inflationary rather than disinflationary. The global economy has had multiple inflationary shocks in the past four years:
- Trade War with China
- Global Pandemic
- Russia/Ukraine
The result has been further deglobalization as the U.S. reduces the risks of having supply chains spread worldwide. Deglobalization in itself is inflationary. You may recall from Econ 101 the concept of comparative advantage. Comparative advantage posits that it is advantageous when economies trade the goods they can produce at a lower opportunity cost than their trading partners. The theory, which supports globalization, posits that both win if trading partners trade their respective comparative advantage outputs. Both save on the higher opportunity cost by trading for something their partner can produce more cheaply than they can. The theory is good, but national security interests have become a more significant cost consideration in the evaluation of the comparative advantage equation.
The Fed was slow to acknowledge their pandemic response’s inflationary impact upon the economy, expecting it to be transitory, prioritizing full employment, and expressing a willingness to let inflation run hotter in the near term. The Fed came to accept they had an inflation problem and in late 2021 made an extreme pivot in messaging and policy towards tightening, which led to the market volatility of early 2022.
What about the Ukraine/Russia War and the inflationary impulse of higher energy and commodity prices? Will it tank our economy?
Barry discussed the 3 implications of the Ukraine/Russia War:
1. Spike in Energy Prices – 4:51: It is different from the ’60s because, in the ’60s, the policy-driven inflation occurred before the OPEC embargo. However, the US is no longer a massive importer of energy. Three reasons we are better positioned this time:
- The percentage of household income that goes towards energy and gasoline has never been lower.
- Household net worth is higher.
- Wages are growing more quickly (particularly for lower-wage earners, which better positions them for the inflationary shock).
The U.S. is better positioned to absorb the energy price increase relative to the past and other nations. The spike in energy prices will be more of an issue for developing countries that run trade deficits and import their oil. (I.e. India). It will also be an issue for China due to the volume of oil they import.
2. Inflation – 2:40: The good news is that prices on core goods and vehicles are peaking. However, pandemic relief spending is now beginning to see its way into core services like housing. Barry’s expectation is that inflation will be down around 4% by the end of the year. We still, however, have yet to see recent spikes in energy and commodities prices filter into the inflation readings. It will appear in the inflation numbers in subsequent months.
3. Deglobalization – 0:58: The trade war, the pandemic & now the Russia/Ukraine war have all furthered the deglobalization trend as companies seek to alleviate the costs and logistics of running worldwide supply chains.
Three factors that are driving improving, sustainable productivity
1. A U.S. capital investment boom is underway. S&P 500 cap investment and R&D levels are 21% above the peak in 2019.
2. Labor productivity – labor dynamism has increased labor market turnover because people are more mobile due to remote work and not being financially locked into their homes as the in great financial crisis. Workers are moving to the jobs they want and as an input to productivity, a higher and better use for their skills and talents.
3. Technology innovation adoption – which surged during the pandemic.
Productivity averaged better than 2% since WWII, but from 2010 to 2017, it only grew at .7%. Productivity has ticked up to 2% and has been averaging 2% since the beginning of 2018.
Can The U.S. economy, corporations, and consumers deal with hotter inflation?
Barry does not support the idea that rising wage costs or the rising cost of goods from commodities and energy will pressure corporate margins or cause earnings to decline. Instead, earnings and margins have been better than expected despite inflation and are likely to go higher this year because of this productivity shock. So, for a time, the U.S. economy can withstand the inflationary pressures.
Does the current stock market correction have further to go?
Barry discussed the present correction and how it correlates to early 2016 when the Fed ended the zero-rate policy in December 2015.
Is now a good time to put cash to work into stocks?
Every business cycle since WWII has had Fed policy-related corrections. While there may be more downside, the market is in the 10-12% correction territory with reduced valuations, an excellent time to put cash to work. Contrary to some beliefs, the Fed doesn’t cause recessions by tightening too much. Currently, Fed policy has been so overly accommodative that their normalizing will be a net positive for 2022. The 1960s had a more expansive fiscal and monetary policy and faster nominal growth, with earnings averaging 8% in the ’50s to 16% in the ’60s. So, while multiples did expand, earnings were strong, driving the strong returns, which may not be dissimilar to what could occur over the next several years.
What about stock valuations? Where to invest?
Stocks are now decently priced against the equal-weighted S&P. Currently, the cheapest sectors are the cyclical sectors and those that are likely to do best in a reflationary environment. Financials are relatively cheap against their long-term average. Energy still isn’t expensive. Materials are not overly expensive. Industrials look expensive but are also the sector that will be the biggest beneficiary of rebuilding U.S. capital stock. U.S. Technology, as a sector, is still relatively expensive, as are staples and utilities. Overall, the market has appropriately adjusted to the Fed and will be able to absorb the energy and commodity-related spikes caused by the Russian invasion. Capital investment and deglobalization will be positive productivity drivers.
Is the financial sector is still attractive? Where should the focus be within Tech?
The first stages of the Fed normalization are a net positive for the U.S. economy. Currently, private sector lending is being crowded out due to excess liquidity in the banking system which impairs profitability. There was 1.1 trillion in bank cash assets pre-pandemic; there are 4 trillion in reserves and 3 trillion in cash now.
What do you mean by investing in the beneficiaries of tech innovation and capacity build-out?
Like the 2000s, the pandemic economy accelerated a technology capacity build-out beneficial to the margins of the sectors adopting productivity-enhancing innovations (cloud, AI, software, etc.). For example, we’ve spent a decade building out the cloud, and now the benefits will be seen by healthcare companies, industrial companies, consumer companies, etc.
Is it too late to invest in the energy sector?
Watch Video – 2:01
It takes three weeks to drill shale wells which can be shut down anytime. In contrast, offshore oil wells are 3-year projects, and if they’re capped, they can’t be restarted. Thus, the shale producer has a more stable return on invested capital because it’s maintenance capital expenditures rather than upfront capital expenses. Presently, the return on common equity in the big E&P names is 15%, while the long-term average is 7-8%. The current measure of cash flow to common energy stock prices is at levels that would be supported by $65-70/ barrel for crude. Progress towards peace in Ukraine will likely put downward pressure on energy sector stocks prices. Barry would view a sell-off in energy stocks as an opportunity to buy as his long-term view for the sector is positive.
If you couldn’t join us, we hope this summary has been a helpful recap on the topics Barry covered and provides insight deeper than current headlines. We find Barry Knapp’s and other analysts’ research and narratives informative. We hope that sharing these opportunities will help you understand the rationale behind the tactical tilts we make in portfolios. Like, Barry Knapp, we are optimistic about the underlying fundamentals in play that will soften and absorb the current inflationary, geopolitical, and Fed policy normalization shocks.
If you would like to discuss your portfolio, please reach out or schedule a review. Thank you for your continued trust.
Tim
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This material contains an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources.
This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward-looking and should not be viewed as an indication of future results.
