In an environment where corporate earnings are likely to face headwinds, earning visibility will be the key
The market and the US Federal Reserve (Fed) are in a tug-of-war. The market is currently pricing Treasuries using a 2.4% CPI in calendar year 2023 and a peak Fed Funds rate of 4.9%. Meanwhile, the Fed’s most recent forecasts point to inflation (as measured by the core PCE) of 3.5% in 2023 and the Fed Funds rate peaking in the 5.0%-to-5.5% range. The realised outcome for inflation and interest rates in 2023 could have a profound impact on equity markets. Pella’s current expectation aligns more closely with the Fed than the market.
Figure 1 illustrates that CPI can be decomposed into five factors: Energy, Food, Commodities less food and energy (“Goods”), Services less rent of shelter (“Services”) and Rent of shelter. Goods and Services as the key considerations when assessing underlying inflation and the inflation outlook. In recent months the key driver of disinflation has been Goods-based inflation, meanwhile, there has been no respite in Services prices (Figure 2).
Figure 2 – Goods and Services CPI; Y/Y
Services are labour intensive, meaning Services-based inflation is driven by the labour market. With the US labour market being the strongest for at least fifty years, in 2022 the US employment cost index increased at its highest rate on records going back to 2001 (Figure 3). Nevertheless, labour has not exerted its newfound power to its full capacity and real wages in the US have declined. Pella anticipates that this is a temporary phenomenon and labour will bargain for higher wages, providing a sticky source of CPI pressure.
Figure 3 - Year-on-year change in the US employment cost index
Figure 4 – Indexed US CPI and employment cost index
For real wages to catch up on lost ground, they need to increase by 7-9%. However, those increases just bring wages up to a level that is commensurate with the inflation rate and do not reflect labour’s improved bargaining power. If labour is to make real wage gains, wages must increase by more than 9% in the short term.
To put some numbers around the inflation issue: assuming that the CPI on all inflation categories ex-services is an optimistic 2.5% in 2023 and services-based businesses only pass through 50% of their labour cost increases, the implied CPI in 2023 would be 3.1%. Pella regards this as a best-case scenario because the non-service sectors will also face wage pressure, which implies they too will need to increase prices by more than 2.5%.
It will be extremely difficult for corporates to pass on such significant wage increases, which will pressure their margins. Meanwhile, the wages that are passed through will place a floor under CPI, meaning inflation is unlikely to settle below 3%. With inflation remaining stubbornly high, the Fed will be forced to either raise interest rates higher and/or maintain high interest rates for longer than the market anticipates. Consumer spending could decline due to higher interest rates, and companies will face earnings pressure due to increasing wages coupled with dampening demand.
Considering the above, Pella is emphasising investing in companies that have relatively high certainty of earnings, with a clear growth pathway, and are trading at attractive valuations relative to those earnings. This entails investing in established businesses with proven, structural, and consistent earnings and de-emphasising younger, disruptive companies that might have grown their top-line rapidly but have not demonstrated consistent earnings.
At the stock level, some of the features Pella is seeking from its investments to deliver earnings certainty include:
- Large and guaranteed order book, such as ASML (NASDAQ: ASML), which has a near global monopoly on lithography machines that are ordered several years in advance; and IQVIA (NYSE: IQV), which provides services to the health care industry under multiyear contracts. Further insights into IQVIA are provided in the Stock in Focus section of this Quarterly Report.
- Large portion of repeat sales, such as Adobe (NYSE: ADBE) which provides critical software applications under a subscription model, and Epiroc (STO: EPI) which sells mining equipment with equipment services contracts.
- High customer retention rates, such as Marsh & McLennan (NASDAQ: MMC), which provides complicated insurance brokering services that require in depth knowledge of customer needs, making it challenging for clients to replace their incumbent provider.
- Consumer necessities in a trade down environment, through exposure to discount retailers such as Dollar General (NASDAQ: DG), 3i Group (LON:III) and B&M European Value Retail (LON:BME).
- Infrastructure businesses such as VINCI (NYSE: VINP) which operates toll roads and airports in Europe.
Investing in companies with the above characteristics provides Pella with confidence in the stability of the Pella Global Generations Fund. Most importantly, as we are only ever investing in growing cashflow-generative businesses, this also increases our visibility towards achieving our capital growth expectations. In an economic environment where corporate earnings are likely to face notable headwinds, stability will be the key to the Fund targeting its financial goals of beating its benchmark, with lower volatility than its benchmark.
You can learn more about the fund below:
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Steven is the Managing Director and Investment Analyst of Pella Funds Management. He has more than 20 years of investment experience. In 2015 Steven co-founded the Pengana International Equities and Pengana International Equities - Ethical...
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