Chris Hyzy: Hey. Thanks, everyone, for joining this week’s Street Talk Call. The concept of today’s call is basically in air quotes called “peak growth,” and we asked that question. There should be a question mark around peak growth. The bond market seems to be - at least many people believe that the bond market, particularly longer dated yields, are telling us that we’ve hit peak growth and that what’s in store over the next year to two years in the back half of the cycle is not only slower second derivative in other words, slower growth in general but also the level of growth. From our perspective, we just can’t see that in the data and we have a very different outlook and a very different view. So we want to go over this concept of so called question mark peak growth and we want to dive into the latest announcement on real GDP growth for the second quarter plus what we’re seeing in earnings announcements and then ultimately conclude with the notion that we are not yet at peak growth.
First and foremost, when you take a look at the second derivative, the slowdown – yes, we are slowing down. It’s very difficult not to slow down when you work off of such a low base and such a high overall number as it relates to the catch up factor. We’ve long said that the fourth stage of the work out process would be the pent up demand stage, and as evidenced by not only the first and second quarter GDP announcements but also what companies are telling us in their earnings results, pent up demand is here. It’s alive and well. In fact, it’s still very early from our estimation but unprecedented peak growth overall is where we’re at. Yes, a slowdown in the second derivative coming off of very low basis and very high growth rates but in terms of the level of peak growth, we are still very much well above average and anything that we’ve seen in the past 20 plus years – in fact, you can go back again to the early 1980s to accumulate such high nominal GDP growth overall and even real growth when factoring in and taking out the inflation levels, you still see real growth some three times, just about two and a half to three times higher than what we averaged in the post global financial crisis years so you can parse the data any way you want. In our opinion, you can call it peak growth as it relates to the actual a second derivative but in the absolute level of growth in this economy, not to mention the global economy, it is our belief that we are not yet there. In fact, we are likely to see even higher levels of growth in the next two quarters.
Let’s look into that story a little bit more. What’s driving this growth? You could take a look at what occurred recently. Nominal GDP growth is more than double. We estimate more than double real growth and that’s because inflation is heading higher obviously. What this does at the corporate level, this supports pricing power. As you support pricing power, and there’s not only excess demand but there’s excess savings out there, the consumer can pay for that pricing power and the corporation can pass that on for the most part. Not everywhere but in a major way in a lot of the areas where aggregate demand is rising faster than the aggregate level of supply. As that happens, revenues tend to surpass consensus expectations handily. We’re already starting to see that. We saw some of it in the first quarter. We’re seeing that in a large way in the second quarter as earnings announcements come through. Again, as revenues go up, the next equation is what happens to operating leverage? Do companies maintain their margins? Do margins expand? If margins are expanding, is it just because of pricing power or is it also because of expense management? What we’re seeing is both and that lends itself to much greater operating leverage than originally expected and then finally, when you get that equation, you get much, much higher profits and that’s what we’re seeing. I’ll detail to the numbers in just a bit but when we take a look at these higher profit estimates, so far in the second quarter 59% of the S&P 500 market cap has reported results. That’s about 50% of the total number of companies so far which is about 250. Revenue growth at this point up until today is up about 23% year over year and obviously, off of an easy base for these growth numbers. Consensus however was up at about up the estimated up 20%. So the coming up 23%. Consensus was at 20%. Earnings growth so far, off of a very, very low base year over year, is up 95%. That compares to up about 70% of what the consensus was expecting prior to this earnings season. Now 90% of the companies at this point are beating on earnings basis and about 80% are beating on both revenues and earnings, so The Street and consensus analysts are still too low in our opinion. Second quarter overall - coming into the second quarter, the original expectations was about $40.00 in the middle part of the first quarter. That was the estimate by analysts collectively. They raised it to about $48.00. According to B of A Global Research the investment strategy team we’re tracking about $50.00 for the second quarter. When you take a look at where the revenue growth is coming from - energy on average so far is up about 69%, in revenue growth, consumer discretionary is 55%, materials 48%, industrials 30%, and then you’ve got baseline numbers that match the S&P in communications, services, tech, and healthcare all above 20%. The drag is still utilities and financials, up about 9% and 7% overall respectively. So just looking at that, the economic sensitives are where the low base numbers were and still are and that’s where the biggest bounce is and therefore that supports our view in the second half that the area of the marketplace that is currently somewhat unloved should be applauded, we believe, by investors and you’ll see that in flows in our estimation and we expect the more economic sensitive areas of the globe as well as the US, both cyclical value and cyclical growth, to outperform.
Let’s take a look a little bit at some of the accurate levels of data. When you look at the strength of the rebound in the economy overall mixed with higher level of inflation, the consensus is off side there as it relates to overall nominal GDP growth. As we said before, nominal GDP growth is running double that of real GDP growth and the big driver of this is not only the significant level of fiscal stimulus, but it’s still the monetization of debt that is occurring in the large central banks around the world to keep the yield curve and cost of capital low and at the same time, as higher inflation moves up, that drives negative real rates. The area within the fed surveys that called this very accurately is the Atlanta Fed. We continue to watch the Atlanta Fed’s forecasts. They’ve been the most accurate as it relates to where nominal GDP is going and whether or not we’re at peak growth. The bond market consistently is detailing out a yield curve that lends itself to a story in which people believe that peak growth is here. Again, we believe that that’s not the case. We believe that there’s distortions in the bond market led by extraordinary fed buying to the tune of about $80 billion just in the treasury market per month and still increasing the balance sheet. In other words, monetizing the widening deficit because of the natural disaster that started in March of 2020 for the most part and continues on to today.
So when we take a look at the overall peak growth story, it’s important to take a look at real GDP numbers and not to go too much into detail here, but the real GDP numbers that came out this morning for the second quarter, the headline number would suggest that we’re slowing down and slowing down much below what the consensus expected. The consensus was looking for real GDP of 8.5% for the second quarter. That number came in at 6.5%. If you didn’t dig into the numbers, you might say the bond market is correct. You might say that some of the deflationists are correct and you might say that the peak growth analyst out there are very much correct, but when you look down into the data, let’s look at where the drag was. The drag was in net trade because of the stronger dollar, that’s number one. Number two, government spending was negative actually coming off of high government spending, so that was a drag. Three, inventories overall did not catch up to the level of aggregate demand. So what were the very high points to create the 6.5%? That’s personal consumption. Personal consumption on a real basis was up 12% for obvious reasons. Pent up demand is alive and well, but more importantly, personal consumption on a nominal basis when you look at pricing power and inflation was close to 20%. Business consumption was also very strong so you’ve got business formation, household formation, household spending, and business spending – predominantly software in its own right - are driving the real GDP number to 6.5% and the drags of the areas that ultimately are due to supply chain disruptions. When you can’t build inventory stuff enough to meet the level of aggregate demand, the demand side of the equation doesn’t go away. They wait for inventories to play catch up. So now inventory catch up should happen in our opinion in the third and fourth quarter, lending itself again in our opinion to higher than expected GDP growth than what the consensus believes.
Thirdly, housing is also strong. Even if you take a look at formation, if you take a look at prices – yes, housing is slowing down but it’s more or less because of a low supply stock. It’s not because demand is slowing down. In fact, inventory’s too low and demand is very high at this point. Buildings are in backlog mode. When demand is high enough for future building even if the building hasn’t been built yet in terms of a house, this leads to commodity prices front loading this future match. When you get frontloading of commodity prices, you get what we saw - lumber prices going close to records, if not at records. Copper going close to records if not at records and this lends itself to a supply-demand mismatch. Once supply starts to come on and demand, even if it stays high, that’s where you get this fall down and that’s what we’ve seen recently in copper and lumber. They’re now starting to estimate that inventories do ultimately begin to catch up within future demand and that’s why it’s come down. It’s not, in our opinion, because growth is overall slowing. So simply put, demand is strong. Demand is growing much higher and much faster than supply whether it’s your supply chain for goods or supply chain for homes so we expect growth and inflation to remain well above average for the foreseeable future.
Last but not least, what does this mean again for earnings and growth overall? It’s still supportive of rising profits. In fact, we expect profits to handily beat consensus not just this final view on the second quarter, but also third and fourth quarter and potentially for all of fiscal year 2022. When you take a look at what’s happening in the yield curve, that keeps the cost of capital low, negative real rates, higher reflationary responses, aggregate demand still much higher than the level of inventories across the board. That lends itself to a longer than expected cycle and also in our opinion higher than expected inflation. So our bull market thesis remains in tact and we would look to add to equities if you are underweight on weakness for long term investors. In this regard, reflation should emerge again in the second half and therefore the value end, the economic sensitive end of the equation within the equity market are about to get tailwinds again in our opinion. That’ll do it for the upfront comments for today. Thanks for listening.
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