Why did powerful third-quarter growth come as such a surprise? Olga Bitel, Partner, Global Equity Strategist and Hugo Scott-Gall, Partner, Portfolio Manager, Co-Director of Research, Global Equity Team, discuss the broad expansion in the U.S. economy, the moderation of inflation, and what to look for in a stock picker’s market.
Hugo: Olga, what if I’d told you on January 1, 2023 that third-quarter gross domestic product (GDP) would be as strong as it’s just shown to have been? I mean, it was exceptional. Would you have believed me?
Olga: Great question, Hugo. As we came out of our New Year’s holidays in the winter of 2023, nearly everyone expected a recession in the United States – and possibly elsewhere. For the third quarter of this year, the consensus estimate from sell-side analysts tracking the stock market was for growth of just half a percent.
Instead, the U.S. economy beat that number tenfold. That is well outside the normal bounds of forecasting error.
Why did that happen? I think analysts underappreciated the profound disinflation that the U.S. economy was already undergoing, and how much tailwind that was going to add to consumers for their real purchasing power and real incomes.
Inflation was perceived to have been sticky. There was a lot of discussion about the U.S. Federal Reserve (Fed) being behind the curve and having to do more to address inflation. At the same time, there was a widespread belief that the action by the Fed was going to tip the U.S. economy into a recession. So not only did analysts get the growth aspect wrong, they also got the inflation projection wrong.
As early as June, we saw year-over-year inflation in the United States that was down to the 2% range, and we’ve stayed largely in the range of 2-2.5% since then. Of course, that means a significant boost to real purchasing power, because wage growth is decelerating but it’s still comfortably above the rate of inflation. That produces tremendous power for consumers, and consumption is 70% of GDP.
Low inflation and strong growth: It doesn’t get any better than this, Hugo.
Hugo: Exactly why was it so strong? Does it have to do with the large amounts of fiscal stimulus the U.S. government has put into the economy? Or is it more to do with lingering COVID aftershocks? Or is it actually more about the perpetual growth machine, the underlying innovative pulse of the U.S. economy?
Olga: The innovative capability is certainly there. We only need to look at Nvidia’s (NVDA) earnings growth over the past several years, although much of the chatter has focused on the multiple – what investors are willing to pay for that growth.
But the more interesting story, from my vantage point, is that what we’ve seen recently is a classic expansion story. In the latest quarter, U.S. consumers were responsible for almost 3% of growth. More cyclically, inventories added a bit and government spending added a bit, but the story here, for now, is really consumption.
In terms of fiscal spending, there’s a lot of ink being spilled on the enormous size of the U.S. government deficit, especially at a time when GDP growth is very strong. While on the surface that is a worrying trend, I would argue that the composition of that fiscal deficit really matters for the trajectory of GDP.
When the government is doling out money that is going into consumption, and there is no investment in future capabilities, in a couple of years’ time GDP growth won’t be able to remain high without the handouts. That would be a detrimental use of government cash, and investors would be right to be concerned about it.
However, this is not what is happening. What’s driving the fiscal deficits in the U.S. is a series of industrial policy actions. The Inflation Reduction Act (IRA) and the CHIPS and Science Act were aimed at improving the investment climate in the United States and incentivizing through tax breaks and various other subsidies for corporate investment in new technologies.
As a result, the deficit is driven not by excessive government spending, because the outlays aren’t growing that fast, but rather by a shortfall of taxes – specifically, corporate taxes that will be absent as a result of subsidies. That kind of deficit, arguably, should lead to stronger GDP growth in several years’ time through investment and innovation.
Hugo: Right. We’re talking about growth in capital expenditures rather than operating expenditures.
So we’ve got good growth and a good reinvestment rate. I heard someone saying on a podcast the other day that nominal GDP of 5%-plus pays the bills. There’s enough growth around for everyone to offer it.
When you see the U.S. 10-year Treasury note yielding 5% and not so long ago it was yielding less than 1%, that clearly has a lot of implications. But we need to understand why it’s where it is. Can you look at it and say it’s good or bad, or it just depends?
Olga: At the end of the day, despite all the noise, the U.S. 10-year yield, which is arguably the world’s most widely used benchmark in terms of interest rates, is a function of two things. It’s a function of U.S. economic growth and it’s a function of inflation.
As we talked about earlier, inflation is settling between 2% and 2.5%. So, when analysts were trying to figure out where the rest of the shortfall was in the yield, it had to be growth. In September, as we were getting close to the end of the quarter, it was becoming obvious that U.S. GDP growth was going to come in significantly above expectations. The Atlanta GDPNow forecast model, which has a pretty good near-term track record, was predicting that, and so were a whole host of other indicators.
As we look further out, is the U.S. a 5% grower? Almost certainly not. Is it closer to 2%? Most likely. That would be a very respectable rate in an expansion.
But what if I were to tell you that looking out five to seven years, the United States could reasonably post an average of 2.75-3% growth? That is a material acceleration to the rates that we saw in the last decade. In itself, it would warrant higher interest rates for longer in a positive way, without inflation being any stronger than 2-2.5%.
Hugo: When you think about the relationship of real GDP and real interest rates, what does that mean for equities as an asset class? How do you think about the interplay of multiples on stocks versus alpha – excess return – for total shareholder returns? Is it possible there is a lot of earnings power around that may be undervalued?
Olga: For some bits of the equities market, this is going to become a lot more challenging than it was in the last decade. If your free cash flow yield is now significantly below 5%, you’re no longer nearly as attractive as you were when you could be used as a bond proxy. We’ve already seen this play out in a significant downward pressure on multiples in some pockets.
At the same time, for growth to be in the 2-3% ballpark range, it must be very broad indeed. To your point, somebody’s earnings growth is accelerating. Maybe it was too low before; maybe it was relatively underappreciated. But it’s not a coincidence that we’ve seen a number of companies where earnings growth is doubling on a one-year view. Obviously, those companies are going to be rewarded with higher multiples, almost irrespective of their starting multiple.
For other equities where earnings growth is stable, they’re going to have to become a source of funds. Strong growth is very good for equities overall, but under the hood we’re already seeing a significant change in the distribution of winners and losers.
That’s the exciting bit about investing in an expansion. That’s what people call a stock picker’s market.
Hugo: Yeah, and what they really mean is: You need to know where growth is. Therefore, it is too simplistic to say higher interest rates equals bad for equities. Because we have to understand what’s causing the higher interest rates: growth. And if there’s growth that can be good for equities, you just need to make sure you’ve got the right ones. Is that the very simple message you’re delivering?
Olga: That’s exactly right. At the end of the day, interest rates are a function of growth. Everything that we’ve just talked about comes back to economic growth. Where is it? Who’s driving economic activity, and who’s lagging? Working out who tomorrow’s winners will be is the challenge, but the question is always the same. It’s just the answer that differs.
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