After assessing the economic landscape, some managers at First Eagle Investments said they are seeing foundational shifts that may require another year or more to work through and are remaining skeptical the U.S. will stick a soft landing.
"A key thing that’s happened in the last 24 months or so is that we’ve made a fundamental transition from a generationally low cost of capital—where the government bond yields were low and credit spreads were low, and P/E multiples in equity markets were high—to a much more normal cost of capital,” said Matthew McLennan, a portfolio manager and co-head of the global value team, as he spoke today on a panel addressing the investment environment.
This has meant that credit spreads have moved from below average to pretty close to their 20-year averages, sovereign bond yields have moved from below 20-year averages to slightly above, and P/E multiples have contracted from very high levels to more normal levels, he said.
This transition has been painful for some of the growth stocks that were sensitive to an increase in the cost of capital, he continued, but the worst of it may lie ahead.
“It’s possible that we may only be partway through this adjustment in the cost of capital,” he said. “Typically one can only say with confidence one has seen worst of a market adjustment when unemployment rates are higher than average, payrolls have been negative for a while, the yield curve is positively sloping not inverted, and equity markets are depressed, not relatively healthy. We don’t really have those indicators of a post-crisis environment.”
McLennan said that New York-based First Eagle has a long-term approach, with a 10-year average holding period and about 10% portfolio turnover.
“The essence of what we do is far more akin to being business gardeners than it is to being stock traders zigging and zagging around markets,” he said. “We think a lot of good things take time to play out.”
As McLennan looks forward, he said a key difference with investing over the next 10 years is that investors are going to have to get used to productivity that will be a lot more sluggish than it has been for several generations. “It’s not that innovation isn’t happening, it’s just there are some fundamental headwinds to productivity that will be weighing on the speed of the global economy’s growth over the long term,” he said.
In particular, the aging demographics of the workforce is one of those headwinds, as are as the emphasis on services, growth in the role of governments in the world economies, the energy transition, and geo-political tensions and fragmentations of supply chains that might occur.
In addition to lowered productivity, some regions, like the U.S. and Europe, are starting this new cycle above trend relative to that slower trend line, he said, as seen by low unemployment, continued payroll growth and plenty of job opportunities, meaning there might be a distance to fall in 2023.
A bit of good news, however, is that inflation may have peaked, said Idanna Appio, a portfolio manager and senior sovereign analyst.
She pointed to two indicators for this: Currently there is deflation in the durable goods sector after inflation there was running at 18% at the end of 2021, and food and energy prices at the end of last year saw much more moderate inflation of 9% following their 20% surge after Russia’s invasion of Ukraine.
“That leaves us with service sector inflation, and that is more worrisome for the central banks. Service sector inflation is still running at very high levels, and at levels that are really inconsistent with inflation targets,” she said, adding that a lag in the data means a drop in service sector inflation should be seen in the second quarter.
Appio said that she’s still skeptical that a soft landing can be achieved for the very simple reason that the historical data in the U.S. shows it takes a period of rising unemployment to bring down wage costs. Because the U.S. has very flexible labor markets, once unemployment rate starts to go up, it tends to keep going up until there’s a recession, she said.
Instead, she said she expects more rate hikes, just smaller than the Fed has moved recently so the Fed can see how the hikes of the past year are playing out.
“A scenario where the Fed is cutting rates at the end of this year is one in which the economy has fallen into a recession, where we do see unemployment increasing and inflation coming down and the Fed feels more comfortable that it will come back down towards target,” she said. “If we’re in a soft-landing scenario and we’re not seeing recession, so growth is just slowing modestly and the unemployment rate has moved up slightly, then I think the Fed is going to be very reluctant to cut rates this year.”
The Fed remembers cutting rates too quickly in the 1970s, and they don’t want a repeat of that, she said, adding that this is the first inflationary cycle featuring global quantitative tightening, which has resulted in a “massive reduction in liquidity, and we have yet to see the outcome of that.”