The full effects of these shortages will likely be felt for some time, probably years. But this week has highlighted the lesson that scarcity means higher costs, more inflation and higher interest rates.
The trends that have defined global markets since the GFC – low inflation, ultra-low interest rates, globalization – are about to completely reverse, in ways markets still haven’t mastered, says Almeida.
“The market is doing a great job discounting what’s right in front of us – the next two or three quarters. I think it’s multi-year momentum, or a paradigm shift.
But as Almeida likes to say, he is not an economist or a politician, but a humble stock picker. It focuses on a simpler question: in a new world of crises, what should investors focus on?
Fortunately, his answer is just as simple: profit margins.
Almeida says that in a market flooded with data points and commentary on every minute movement of macroeconomic conditions, it makes no sense to waste time and energy “counting how many times [Federal Reserve chairman] Jay Powell blinks.
“Let’s get back to what matters. You finance a company. What does the income statement look like and what will it look like? And how much do you pay for that?
Almeida thus condenses the regime change in the markets.
Benefits are a function of revenues and costs. On the revenue side, it is clear that economic growth is slowing, which will weigh on revenue. Obviously, soaring inflation means that costs are also rising. Earnings are expected to fall, which means corporate valuations and stock prices must fall.
This is the simplified version, but it doesn’t tell the whole story. While the direction of the margins is important, what Almeida is really focusing on is the magnitude of the drop we may be about to see. And that goes back to what central banks and governments have done since the GFC.
A very different world
It may be hard to remember now, but profit margins around the world were actually at record highs just before COVID-19 emerged in 2020. They briefly dipped when the pandemic hit and the world went into lockdown, but as waves of and monetary stimulus were unleashed around the world, margins surged again, eclipsing pre-GFC highs on their way to new record highs.
It is important to ask why margins were so high before and during the pandemic.
Before the pandemic, economic growth around the world was tepid at best, so strong margins were a cost story. Companies were outsourcing labor, using just-in-time supply chain management to reduce working capital, and taking advantage of cheap capital to reduce borrowing costs and, in Almeida’s words, “financialize” other parts of their business, such as payables and receivables – the factoring products offered by the collapsed lender Greensill is a good example.
When the pandemic hit, margins were doubly boosted – incomes rose as confined households splurged on goods, and businesses “cut all costs that weren’t nailed down”, including travel and marketing.
Almeida argues that a very different world has now arrived.
Economic growth is slowing, so incomes will fall. But the most important factor is what happens to the costs.
Business costs are back
First, those legacy costs that were reduced during the pandemic are coming back – as a simple example, Almedia highlights the fact that he’s back in Australia talking to customers, and not on Zoom.
But on top of that, a new set of costs is emerging.
Companies are finding it much harder to cut payrolls by outsourcing labor, and industrial action is growing around the world as rising inequality leads workers to demand a bigger share of profits.
Rising environmental standards and expectations are forcing companies to spend more on their operations. Regulation increases as ESG issues become more important. From modern slavery rules to recycling, Almedia says compliance costs – and non-compliance is no longer an option.
The energy cost crisis in Australia could be put in the same basket.
Prior to COVID-19, the energy security challenge was mostly theoretical, but it is now clear that it will impose costs at levels unheard of just a few years ago.
And then there is the rising cost of capital. Almeida says that with global inflation hovering between 6% and 9%, central banks have no choice but to keep raising rates to the point of destroying demand.
The central bank does not care about stock prices. They care about inflation. They must create pain.
He says the market’s obsession with the idea of a Fed put – the level at which the Fed will ease monetary conditions to support stock prices is misguided because society simply cannot live with it. inflation at these levels for extended periods.
“The central bank doesn’t care about stock prices. They care about inflation. They must create pain.
Does this mean a recession? Almedia doesn’t know and says its best estimate is a 50% chance of a US recession.
But again, it comes down to profit margins. What higher rates will do is make financialization techniques – borrowing to finance shareholder returns, factoring debts and receivables, operating without making a profit – a headwind rather than a tailwind.
Almeida’s conclusion is relatively simple: too many companies have earned too much for too long and profit margins need to fall by around 40% to 55%.
The last time profit margins fell 50% was in the GFC – when stocks also fell 50%.
Clearly, Almeida is of the view that the current equity market correction is far from over and investors should be prepared for more pain and certainly more volatility.
But on the other hand, these conditions give stock pickers the chance to prove their mettle. Margin risks are neither complicated nor hidden. Companies that run sustainable businesses, that pay their employees well, and that haven’t over-revenued in a decade, should stand out in times of scarcity — of energy, labor, and returns.
“The market is going to be able to price risk,” says Almeida. “Companies that should never have gotten capital will disappear. This is going to create an opportunity for that better or better business that is going through this to take a growing market share on the other side.
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