FOMC’s inflation model fails, interest rate sensitivity, capex drought

Growth investing and inflation

The FOMC meeting will not be the event that takes us to new levels on US interest rates and cause a bigger sell-off in equities. Inflation data (m/m figures) over the summer months will be key for market dynamics and interest rate direction. As long as consensus is 72% of institutional investors believing in transitory inflation interest rates will be well behaved and growth stocks will not lose a lot terrain to value stocks. With this consensus the likelihood of a ketchup effect on interest rates is high and if we are right about the inflation dynamics (more on that later), then we got get another sell-off in growth stocks later this year on par with what we saw earlier this year. The ‘go-go years’ in the 1960s were also about growth stocks in the US and the 1970s inflation period changed that dramatically. Growth investing is a more difficult discipline under rising inflation and interest rates. More importantly the low free cash flow yield observed in equity growth pockets and the Nasdaq 100 means that the interest rate sensitivity is quite large and could surprise many investors if inflation sticks.

There are several reasons why we believe inflation will turn out to be stickier than what the market and the Fed believe. Fiscal stimulus cannot meaningfully be reduced as it will weaken the economy into a 2022 US midterm election which is not a political option for the Biden administration. It is much more likely that fiscal deficits will remain higher for longer adding long-lasting fiscal impulse keeping GDP above its potential for longer than expected. If the transfer income schemes remain then businesses relying on low-wage workers will have to bid up wages to get them back into the labour force and hike prices to offset the increased wage costs. Lennar’s Q2 earnings yesterday was quite interesting in that the US homebuilder is lifting its fiscal year guidance for gross margin to 26.5-27% from previously 25%, indicating that the homebuilder easily can pass on rising input costs and expand margins. This is a sign of strong demand and excess buying power. In other words, the market is not in equilibrium yet and prices can rise further.

Green transformation and the capex drought

The potentially biggest driver of inflation going forward will come from the green transformation under an accelerated decarbonization policy in the US, Europe, and China. It is the biggest physical transformation of our society since WWII and will require enormous amount of capital and physical resources putting immense pressure on our technologies and resources. A few clients have recently shot back at our view saying mining will just expand capacity because higher prices incentivise them to expand. This sounds in theory and is likely also the long-term reality, but in the short-term the reality is very different. As the chart below shows, capital expenditure in the MSCI World Materials and Energy sectors (covering global mining, metals, and energy industries) has dropped 65% from the peak in real terms (adjusted for inflation) and is now at the lowest level since 1997.