Confused by the markets so far this year? The big narratives in 2023 have seemed to conflict, with key indexes like the S&P 500 up despite fears of an earning slowdown, a possible recession, and Fed rate hikes. In a wide-ranging equities outlook discussion by Richard Bernstein Advisors (RBA) titled "Inflation: Yesterday’s Story or a Secular Change,” however, CEO Richard Bernstein outlined a narrative throughline aiming to reconcile those narratives based on the firm’s profits cycle-focused research.
Much of 2023’s story centers around the Fed, but for Bernstein, the important question is not what should the Fed do, or whether a pivot from the Fed would have to be more than just a rate hike pause, but rather how investors perceive the Fed’s actions and what they might mean. RBA’s profits cycle-driven investment thesis prioritizes three factors: profits, sentiment, and liquidity. It’s the latter that Bernstein focused on regarding the Fed.
“The First Market in Any of Our Careers Based Purely on Speculation”
To Bernstein, the areas that drove so much market growth last year and to start this year are areas supported in large part by speculative investing in disruptive tech and cryptocurrencies.
“It’s very clear that first quarter performance was predicated on some idea that we are going to return to an environment of cheap and abundant liquidity. It’s important to understand that’s the lifeblood of speculation is cheap and abundant liquidity,” Bernstein said.
In RBA’s view, that liquidity environment is not coming back soon, especially with GDP still some way from recession territory for easing. That would require “substantial” negative surprises in the economy, as well. Bernstein underscored that investors have been too myopic in focusing on the Fed’s action — or lack thereof — on rates and missing out on the fundamentals in areas like the yield curve, for example. The yield curve isn’t just a signal, but, driven by central banks, it also directly slows lending.
See more: " RBA’s Bernstein on 70s’ Inflation, Speculative Investing ”
Profits are another market fundamental that goes missing in Fed-specific discussions. While some investors might want to believe that if projections show three more quarters of deceleration, market watchers can “look through a profits recession,” that is unfortunately not the case, per Bernstein. Markets never look past profits recessions, especially as earnings tend to lag, i.e. weakness has an impact before earnings drop.
Don’t Trust Every Positive Earnings Surprise
So if the first quarter was driven by hopes of a return to a liquidity environment conducive to speculative investing, and we still have a few quarters of profit slowdown to go through, then what explains the positive earnings surprises for a number firms in the U.S. to have reported so far? To Bernstein, it’s a case of trust and a market signal that is losing informational value.
“If you go back to the early 1990s, you would have found that positive and negative earnings surprises were roughly evenly split,” Bernstein said. “What’s happened over the last 30 years as an investor relations officers have learned that investors like positive surprises. And so what they do is they talk down the analysts, jump over that lowered hurdle, and they manufacture positive surprises. So guess what, over the last 30 years, the information content of positive surprises has gone down.”
That’s added to the informational value of negative earnings surprises, in turn, but given the drop in information received from positive surprises, the more-positive-than-expected turnout for earnings so far for Q1 may be a bit misleading.
At the same time, only about a third of firms have reported so far this quarter, Bernstein said, and that’s just for the U.S., let alone the rest of the world — in fact, the U.S. has seen a disproportionate number of negative earnings surprises that would actually support a profits recession narrative in line with RBA’s research.
Taken together, that paints a picture at RBA of a first quarter that is more of an outlier than a trend driven by fundamentals, he added, and the firm has kept to defensives in this environment.
Long Term: De-Globalization and Real Productive Assets
These trends and observations themselves are part of a broader story for Bernstein that ties inflation to “deglobalization.” Geopolitical rivalries and straining alliances threaten to end the trade agreements and financial arrangements that defined the last several decades, in which more global competition pushed down prices.
With those factors weakening, for example as the China and the U.S. trade war continues, “deglobalization” will see the cost of U.S. imports particularly rise, driving secular inflation. In such an environment, Bernstein explained, the future growth stories are going to focus not on disruptive innovation and fringe investments in areas like the metaverse, but in real productive assets.
“We think that the long term growth stories … are not going to be about cute wiener dogs in the metaverse, they are not going to be about artificial intelligence, they are not going to be about space, vacations, and travel to Mars and all these things. It’s going to be about real productive assets,” Bernstein said.
“We’re all believers in capitalism, our view is a capital will flow to assets that benefit from or alleviate inflation. That’s going to be the story over the next five, ten, fifteen, twenty years,” he added, pointing to the U.S. trade imbalance as a key driver of domestic investment in industries that can alleviate those import costs.
Taking all the above together, RBA is focused on defensive areas, overweight to defensive sectors like staples, healthcare, utilities, and dividend paying stocks, and underweight in areas like the “sexy stuff”, Bernstein said, including financials due to the inverted yield curve.
See more: “ Q&A With RBA’s Director of Research, Lisa Kirschner ”
Investors interested in an ETF that packages the RBA approach in that wrapper may want to check out the iMGP RBA Responsible Global Allocation ETF (IRBA ). IRBA charges 69 basis points and actively invests according to RBA’s profits cycle approach which invests according to the path of profits, either accelerating or decelerating.
IRBA allows investors to use “pactive” investing, actively shifting between passive ETFs to express a particular fundamentals-driven, macro view with an ESG overlay. IRBA has outperformed both its ETF Database Category Average and its Factset Segment Average over the last month, as well.
For more news, information, and analysis, visit the Richard Bernstein Advisors Channel.