By Alister Hibbert and Michael Constantis, Portfolio Managers, BlackRock Global Unconstrained Equity Fund
Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
The biggest issue for investors this year, in our view, is the potential magnitude of the global economic slowdown, as central banks around the world raise interest rates in an attempt to bring down inflation. This argues for an increased focus on portfolio resilience, in our view – and particularly an emphasis on quality stocks.
Coming into 2022, we carried the conviction that the strongest phase of the post-pandemic recovery, where corporate earnings soared and sectors most correlated with economic growth outperformed, was behind us. This view has only solidified since.
Consumers power the economy – personal consumption expenditure represents 70% of U.S. GDP – and they are faced with higher housing, energy and food costs at a time when pandemic-era government stimulus measures are wearing off.
Credit card data suggest that lower-income consumers are curtailing spending at a faster rate than those with higher incomes. See the chart below. John Rainey, Chief Financial Officer of Paypal – the online payments company – has also noticed this trend. “We’ve seen weakness around spending in our lower income cohorts,” he said on a conference call in February this year, “and this was a cohort that certainly benefited from stimulus in prior periods.”
Spending subsiding
Change in U.S. consumer credit card spending versus two years earlier
Source: BlackRock, March 2022. The chart shows the growth in U.S. consumer credit card spending, versus two years earlier, divided into the bottom 40% of earners, the middle 40% and the top 20%.
Energy prices are the most acute problem in Europe, which imports more than 40% of its gas from Russia, according to the International Energy Agency. Energy bills were soaring at the start of the year and the war has made this situation more severe. The impact of sanctions on Russia and supply disruption in Ukraine add to what was already a very stretched oil and gas market. The result is that Europe’s energy bill has risen to nearly 9% of gross domestic product (GDP), up from 3% in 2019. See the chart below.
Feeling the heat
The European Union’s energy bill as a percentage of GDP
Source: Bloomberg, BP Statistical Review of World Energy, IEA, World Bank, UN Population Division and BlackRock estimates. Note: The energy prices used are the regional spot commodity prices on March 10, 2022.
Energy prices have not leapt so dramatically in the U.S., which is less reliant on energy imports. Yet homebuyers in the U.S. face the dual hit of higher home prices and higher mortgage costs. The average 30-year fixed mortgage rate has soared from 3% in 2021 to well over 5% today1.
Housing and energy costs are a significant threat to global growth, in our view, but prices more broadly present a challenge. Food prices are rising as wheat trade from Russia and Ukraine is disrupted. Exports from these countries represent 12% of all calories traded globally2. The Organisation for Economic Co-operation and Development estimates the disruption to supply caused by the war in Ukraine will send world output 1.1 percentage points lower this year than it otherwise would have been. And supply chains remain stretched due to the surge in pandemic-era goods demand, a problem exacerbated by the ongoing impact of COVID lockdown policies – especially in China – adding further upward pressure on input costs.
Major global companies are increasing end prices as their costs rise. Kellogg’s said it will raise prices by high single digits in the second half of 2022. Next – the fashion retailer – plans a similar price increase. Infineon and STMicroelectronics said the prices of the semiconductors they supply to the auto industry are going to see a mid-year rise, which is very rare for the industry3.
Soaring inflation is a serious challenge for global central banks. One major risk we are monitoring is that to bring down inflation, the Federal Reserve – the central bank with the greatest influence on global markets – could raise interest rates to the extent that consumer demand is damaged and the U.S. economy enters a recession. Anticipated rate rises are already adding to debt costs, as with the mortgage rates mentioned above.
We see three reasons that the global consumer could be strong enough to withstand the inflationary pressures, thereby supporting businesses in the near term.
- First, consumer savings provide a buffer against higher prices. Globally, consumer savings rose by US$6 trillion between 2019 and 2021, as the COVID pandemic forced spending to slow, and as governments ramped up fiscal stimulus4. And median cash balances among low-income families in the U.S. were still 65% higher at the end of 2021 than they were in 20195.
- Second, nominal wage growth should offset some of the impact of negative real (after-inflation) wage growth. Higher wages help with higher prices. More than 90% of U.S. companies plan to raise wages in 2022, according to PayScale, a compensation analysis firm.
- Third, consumer credit levels appear to have room to rise. In the U.S., credit card borrowing levels are accelerating, according to the Federal Reserve, but remain below the pre-COVID peak. If consumers need to borrow to offset higher costs, they should still be able to.
Yet all three of these points of strength have time limits: Savings may start to dwindle, inflation may continue to out-run wage growth, and the ability to borrow may peak. Beyond the consumer, the higher cost of debt may curtail capital investment plans at industrial companies, and once free-spending technology companies may begin to cut costs as investors focus on profitability.
Therefore it is key, in our view, to invest in those companies that can generate cash and protect profit margins even as growth slows and input costs remain high.
Consumers may weather the storm, but the economic path ahead remains uncertain. We believe it is important to invest in quality companies that are highly profitable, have strong market share and consistently grow their earnings and cash flow – regardless of economic conditions. We look for the following characteristics when seeking to identify these companies:
- Pricing power. Companies that can pass rising costs on to their customers are poised to withstand periods of inflation. Pricing power often comes with a strong brand. Luxury goods companies with loyal customers might even be able to raise prices beyond inflation. This might also apply to high-end sportscar companies that cap the number of cars they produce to make them more desirable. Strong brands can also expand market share during periods of economic volatility, capturing demand from weaker rivals and growing through acquisitions.
- Asset light business models. Another way to avoid inflationary pressure on profit margins: avoid input costs. Asset light companies are those companies that don’t buy large quantities of raw materials to make goods, or those companies that don’t need to invest heavily in plants and equipment. Dominant software, online advertising and information services companies fit into this bracket, as well as powerful payment companies. Wages make up the biggest costs for these companies, but many have large enough margins to absorb wage inflation.
- Defensive features. We define “defensive” as companies with cash flows that are not expected to fall significantly during an economic downturn – and have proven this during previous episodes. These companies should also deliver resilient, long-term growth. Companies selling essential goods fit into this category – especially those with a strong membership model. Healthcare companies are also typically untied to the economic cycle, although it’s important to be selective. We look for healthcare companies with a robust pipeline of treatments for illnesses that become more prevalent as populations age.
We believe that careful stock selection, informed by fundamental research, powerful data and meetings with management companies, is essential to portfolio resilience in times of uncertainty – and can have a profound impact in the pursuit of long-term financial goals.
1 Source: Mortgage Bankers Association.
2 Source: International Food Policy Research Institute.
3 Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies.
4 Source: Moody’s Analytics.
5 Source: J.P. Morgan.
