GW&K Investment Review 3Q 2022
We all have experienced the impact of this pandemic in our own way, but now is the time to examine macro developments and imagine how events will evolve from here.
The impact of wages, employment, and inflation should be considered through a single lens. As a backdrop, we all know that US immigration policy was not designed to boost our workforce. We also know that our birth rate has dropped below the replacement level. So first and foremost, the supply side of labor is constrained. This was the case before Covid and it has only worsened. The shortage has been further impacted by a combination of events: workers 55-years and older dropping out of the available candidate pool, an explosion of entrepreneurship and the desire to work from home, particularly among white collar workers. Companies have needed to address employee desires and be sensitive to their attitudes and demands. The shift in the employee/employer relationship is not being forced by unions, which has often been the case the last 100 years, but by the fear of losing a competitive advantage in the face of a limited supply of talent. Thus, the impact of post-Covid worker attitudes has driven a new dynamic in the workplace.
So, what do workers do with this new power? They ask for higher wages and additional benefits. And how are these wages rationalized in a declining economic environment? The classic answer has been to raise prices and keep margins in place. Is that model still intact? Will employers be able to pass on price increases in a system that is not enjoying real growth? Obviously, it depends on several factors. In many industries, there is no room for price increases and the result will be that businesses will need to adjust margin expectations.
If the global economy was as healthy as it was pre-Covid; pre-Russian invasion of Ukraine; pre-China’s zero-tolerance policy, one could argue that businesses, as they have for the past 20 years, will find offshore opportunities to keep operating expenses in check. But in a post-Covid world, the opposite is true. Companies now seek more domestic solutions to avoid the challenges of supply-chain interruptions.
The magic bullet to margin pressures, of course, is higher productivity. Can businesses solve the growing tensions between their top and bottom lines by increasing efficiency, whether through technology or consolidation? The answer is that some can and will, while others will not be able. No doubt some companies will need to shrink to right-size their business models. We have been trained that bigger is better, but this is not true for all industries. Restaurants have shrunk square-footage, hospitals have eliminated services, airlines have scaled back flight routes. Even in the daily routine of home life, we have all experienced the shortage of contractors, plumbers, and electricians.
What does this mean for the stock market? Even looking past the next couple of years, after shortages disappear, inflation moves back toward baseline and short-term rates retreat, what is the long-term opportunity in a shrinking economy? Will we experience stagnation like Japan, or will we be different?
Inflation will decline but real growth will still be more difficult. For equity investors, this feels like one of those “stock picker’s markets” we’ve seen so often in history, where results will come from identifying select opportunities rather than riding a great wave. Not such a bad environment. The bond market should also take on renewed interest, with intermediate and long-term bonds now at attractive levels. The Federal Reserve’s resolve to curb inflation provides a great opportunity to begin to lock in decent cash flow.
As a true believer in capitalism I think there are always opportunities to make money, but it won’t be as easy as the last 20 years, especially in the US. Speculation and unbridled risk amid zero interest rates were not sustainable. This next phase, however, should create a healthier base. I also believe in the need to invest overseas. While Western democracies try to stabilize after the free money era, Eastern economies will continue to grow as their populations enjoy the benefits of a more integrated world economy. The pace of globalization may have been slowed by the pandemic, but it is simply too strong a force to be held back completely. While diversification has always been important, in today’s very complicated world, investment portfolios must supplement a foundation of domestic stocks and bonds with international exposure.
As we look out five years, we will see this market correction as a wonderful opportunity. As I have often written, while we could stay in a trading range for a while, we are setting a new base for a bull market.
For those of us who manage assets, it is a mistake to stare through the rearview mirror. The beauty of this business is that it is all about looking to the future and finding new opportunities.
Harold G. Kotler, CFA
Founder-Chairman, Chief Investment Officer