Inflation vs. Stagflation: A Distinction Without a Difference?
For the better part of the last decade, interest rates have been near zero and leverage drove asset prices higher. Meanwhile, wage gains remained stubbornly low. The economy was not strong enough for the Fed to raise rates and shrink the money supply, but inflation looked to be inevitable despite. Even so, banks were still not increasing consumer lending. Fortunately, the stagflation scenario predicted as imminent by some economists never quite came to pass… yet.
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Labor Costs: Wall Street Cried Wolf, Now Investors May Get Eaten
Between low labor cost assumptions and the actual impact on some companies, we expect Wall Street is being too optimistic in its margin and earnings assumptions (and thus equity valuations) for many companies. At Zeo, labor costs are at the front of our minds when we are evaluating companies. Because we focus in on a smaller universe of issuers, it is easier for us to consider such line items on a company-by-company basis. Meanwhile, it is important to recognize that our view that ESG factors are credit factors also goes a long way to heading off such issues. By including labor relations in our creditworthiness evaluation, we end up selecting companies who are likely to be less susceptible to these issues as they play out over the coming years. After all, in our experience, happy employees tend to mean productive companies.
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Snakes in the Grass
One major lesson we have learned in our decades investing in the capital markets is that investors get the most painful bites not from the snakes they are watching intently but from the ones they don’t see lurking in the grass. We have all read a lot about supply chain disruptions, energy prices and (most of all) inflation. But what has been particularly interesting to us are not the circumstances themselves, but the lack of critical thinking found in the lazy interpretations of Wall Street economists. Investors rely on such “experts” not to point out what is obvious to the naked eye but rather to reveal what is hidden and to help anticipate and prepare for the unexpected. Like credit ratings agencies, economists will ultimately be reactive to the news, moaning that the next issue, just like the current ones, came out of nowhere. But they didn’t really. They were in the market’s blind spot all along, potential outcomes which investors have been lulled into ignoring, disguised in the grass.
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Not All High Yield is Junk, Not All Junk is High Yield
Credit spreads are at historically tight levels. Short-term interest rates (and therefore interest income) are likely staying low for the foreseeable future. The rate curve is poised to steepen to potentially unprecedented levels as inflation fears grip the markets. The global pandemic has not gone away and may be accelerating toward a second (though probably less severe) public policy reaction. And fixed income investors aren’t getting sufficiently compensated for taking on longer-term or equity-like risks.
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