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Macro Continues to Call the Shots

In our opinion, 2022 was mostly about the bear market that was brought on by rising inflation and our Federal Reserve engaging in interest rate hikes to combat high prices. We have spoken and written about our notion of the interest rate-led bear market giving way to an earnings-led bear market. We believe the earnings-led bear market has begun as inflation (measured by CPI or PCE has likely peaked). Upon examination of recent LEI (leading economic indicators) reports, we can see many signs of a slowing economy. The Fed’s tightening of financial conditions is causing the desired effect of slowing growth. Now the big question is what does the risk to 2023 earnings look like? The graph below shows LEI has just started to dip into contraction territory. As we all know history doesn't always repeat but tends to rhyme. As we look at prior economic down cycles and recessions stocks tend to bottom as the LEI bottoms. If we look to history as a potential guide it appears that a further move lower in LEI is on the offing before we can turn the corner on our current earnings-led bear market.

Even though the overall move in earnings for US companies may be lower during the first half of 2023 there are a couple of macroeconomic trends that we believe will yield interesting investment opportunities.

De-globalization and reshoring of manufacturing are two related concepts that are resulting from competitive global superpowers whose relationships have been deteriorating. It is our observation that tensions between the US, Russia, and China are fairly mainstream topics in most US households, so we will not discuss the details here. The US has announced intentions that would have us rely a little less on our neighbors for energy and manufacturing. Two significant pieces of legislation were passed in 2022 that we believe pave the way for increased targeted domestic capital spending; The Inflation Reduction Act and the Chips Act. The inflation reduction act targets many areas but chief to our discussion, the act is providing funding for electric vehicles, clean energy, and energy grid infrastructure improvements. The chips act is fairly straightforward in that it supports the construction of semiconductor manufacturing facilities in the US. Now, the way I read it, we are on the verge of a significant construction cycle in order to tackle the objectives of these laws. We’ve identified a couple of sectors that we believe will benefit over the coming years.

Engineering and Construction. Whether you are talking about the construction of nuclear power plants, solar farms, or semiconductor plants corporations must hire a specialized company to accomplish the job. Engineering and construction companies will be essential to carry out the specialized work that is on the come. We believe that many of these companies will see a record backlog of business thus providing investors with visibility on the top and bottom-line trends in 2023 and beyond. I think this group will be unique as I dare say there will not be many companies in the US that will see record orders on their books for 2023. It's that visibility on future cash flows that we believe will keep the sector in favor with investors in 2023.

Both pieces of 2022 legislation also raise the case for metal and commodity consumption. We believe the demand for steel, copper, aluminum, and other metals will be elevated when compared to other periods of pre-recession in the US. Normally I would steer totally clear of cyclical metals like copper headed into an economic downturn. We believe the situation as we head into 2023 is a bit unique. Electric Vehicle (EV’s) batteries use base and precious metals and are projected to grow at a 28.1% CAGR through 2028. The EV batteries are in competition with traditional uses of metals and in our opinion may keep prices elevated during a recession and result in a larger increase in price as growth returns to our global economy. The other bullish situation is the relatively depressed current inventories of the red metal, pictured below.

So really we appear to have a situation that has both a bullish supply element, when it comes to copper, and what looks to be fairly buoyant demand in 2023. We have only been speaking of dynamics here in the US, if one were to consider the re-emergence of China and their efforts to rely less on global neighbors for their supply chain that further strengthens the bullish argument for metals in 2023, in our opinion.

Are you familiar with the T.I.N.A. acronym? It stands for “There Is No Alternative” and references a prior bull argument in favor of stocks. I say prior because the notion is patently false now. The short end of the yield curve (1-3 years) is currently yielding above 4%. In our opinion growth is currently slowing quite rapidly and it is very likely that inflation has peaked. Many economists believe that inflation is largely a function of the money supply (M2). As goes M2 so goes inflationary indicators. Here is a recent chart of CPI vs M2. Now, if this trend continues we may very well be looking at deflation at some point in the second half of 2023. We believe this could be a very attractive environment for treasurys. I am not sure the entire treasury curve is currently attractive, let's take a look specifically at the 2-year treasury. Jeffrey Gundlach is one of the most successful fixed-income investors in the world, in my opinion. His opinion, which is shared by others, is that the 2-year treasury discounts the terminal fed funds rate in advance. The 2-year hit its high in terms of yield on November 2 at 4.7%. If we think about what the aforementioned LEI are telling us about growth and the direction of M2, in our opinion the 2-year has likely peaked in terms of yield. Which would correspond to a Federal Reserve that is towards the end of its hiking cycle, which we think makes sense. Now I will grant you that a 2-year treasury may not sound like the most exciting investment. But in a world where we have slowing growth, forward corporate earnings assumptions still elevated by our work, and potential deflationary forces at work it starts to sound fairly interesting.

We believe that 2023 will likely see the end of the current earnings-led bear market. However, in my experience the sectors and stocks that led the prior upcycle are seldom the same in the next expansionary phase. We believe that the pendulum has started to swing back towards active management of investment funds as a way to capitalize on future trends. All the best for a healthy and prosperous 2023! We will be back to you in 2 weeks. In the meantime, feel free to reach out [email protected] !

For information on our actively managed models or to view our Fact Sheets, please email [email protected].

Cheers!

Frank & the Grinnell Capital team

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IMPORTANT DISCLOSURES:

Advisory services are offered through Grinnell Capital, LLC, a Utah Investment Advisor.

This information is a general publication that reflects our opinion and is not a specific recommendation to any one individual. You must consult your own broker or investment adviser for investment advice.

This newsletter is provided for informational purposes only. The information contained herein should not be construed as the provision of personalized advice and is subject to change without notice. This material should not be considered as a solicitation to buy or sell any asset or engage in a particular investment strategy. Investing in securities involves the risk of loss, including loss of principal invested, and may not be suitable for all investors. Past performance is no guarantee of future results. This newsletter contains certain forward-looking statements which indicate future possibilities. Actual results may differ materially from the expectations portrayed in such forward-looking statements. As such, there is no guarantee that any views and opinions expressed in this newsletter will come to pass. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change without prior notice. Additionally, this newsletter contains information derived from third-party sources. Although we believe these sources to be reliable, we make no representations as to the accuracy of any information prepared by any unaffiliated third party incorporated herein and take no responsibility, therefore. This newsletter is provided with the understanding that Grinnell Capital, LLC is not engaged in rendering legal, accounting or tax services and we recommend that client seek out the services of professionals in these aforementioned areas.