Stagflation? Best Sectors for 2023!

Let’s begin with where we are now.

Earnings are under pressure. As rates rise, we experience not only rises in costs of debt and capital for businesses, but future valuations are also diminished, and growth is further slowed adding to compressed margins.

Margins are compressed with rises in the costs of capital, debt, production, labor. As a result, COGS & operating expenses are much higher. Seemingly, Revenues are being held up more so by inflation and increased prices than higher output/vol. Inflation works both ways.

Productivity is down. Less output/$. Marginal costs have increased significantly.

Dilution of value. We are getting less output for each input.

Inflation appears to be embedded at all levels.

Deterioration of profitability is the next challenge in my opinion.

I repeat, Corporate Earnings are already under pressure due to compressed margins and slower growth and I believe should continue and most likely worsen into next year with continued slowed global growth and rising rates and upcoming employment issues as well. Therefore, I would exercise caution with the 60/40 positioning as equities could experience further downward risks especially with stagflation potential. It hasn’t been working for most of this year except for “select stocks” (fundamentally sound and value focused). The bond bear market this year may have some temporary relief however sustained upside is uncertain.

Regardless, we always remain flexible and change our minds and positions accordingly and quickly as we receive new information.

Both capital losses and weaker corporate balance sheets are likely to be increasing and thus contributing to further lowered productivity and capital stock.

With such a tight, strong labor market it is difficult to classify that we are in a recession, but I believe we are most likely headed into one and potentially a stagflationary one. If we asked the American people if they “felt” we are in a recession, they may acquiesce. From a manufacturing business perspective where contraction is commonplace, yes. Maybe an “atypical” one? Nevertheless, I believe inflation may persist and maintain elevated levels for some time. Possibly mid next year.

Let’s look towards manufacturing for some more ideas here. Manufacturing data tends to be a forward indicator for earnings as well as trends. Per recent data in addition to my perspective from the manufacturing forefront.

We began experiencing the slowdown late 2021/early Q1 2022. Productivity has been declining as there is less output/$ as more capital is required to produce each output. There has been a change in the worker as well. Bottom line, when companies reinvest their profits, the real output produced for every nominal dollar invested keeps decreasing.

We have also noticed that there is a rotation of sectors & industries as well as businesses making their Capex purchases, which is closely in line with PMI, ISM, & manuf indexes. Although our business data is only a sample it is very reflective of the prevailing data.

Fewer startups (which have waned significantly lately as they are more sensitive to rises in costs for expansion & maintaining CF while margins are compressed)

More larger established companies as well as mid-large cap publicly traded companies (which have comprised a larger portion of our sales lately depending on industry which I will highlight)

Rotation into more inelastic industries including Industrials & industrial production; Aerospace; Machinery; Transportation Equipment;

More consumer staples; chemicals

Also increase in medical business – prosthetics, orthotics

Industrial production: Turbine engines, metal molding & casting,

Overall LESS consumer discretionary businesses are making CAPEX purchases

Spending patterns have changed and as businesses and consumers get squeezed these trends should continue. Debt is rising, savings are decreasing

Of course, everything is subject to change upon many factors. We can only speak with certainty about what has and is occurring but hypothesize on the future based on this current data against historical patterns, but no one knows the future.

These are challenging times nonetheless however challenges bring new opportunities

Therefore, in my opinion these are Opportunistic times for businesses and investors.

This is when businesses grow and seize opportunities. Adapting and innovating by streamlining their businesses processes to gain market share through organic growth and vertically and horizontally integrate through inorganic growth.

Remaining liquid to seize opportunities is key as there will be many. We have seen this historically during and after economic crises.

Into next year, commodities and inelastic industries are some areas I am looking at as well as holding cash.

Metals and sugar. Gold Silver other metals, lithium, fertilizers, agriculture.

The defensive, more inelastic industries which are necessities such as utilities, health care, medical equip, biotech, consumer staples and “select” technology such as cybersecurity (which may also be a necessity) and/or renewables with SOLID fundamentals could fare better. Fundamentals matter. Especially with rises in costs of debt and capital, therefore I look closely at CASH – FCF, FCF yields, FCF margins, rising earnings, future guidance raises, etc.

However, I am cautious with equities and the 60/40 portfolio and am looking more towards commodities and remaining liquid with cash.

Most real assets have NEGATIVE expected returns in this current environment and then add inflation on top of that. Having cash at least only has the inflation factor.

CASH is king.

Therefore, a larger cash position to remain liquid to seize opportunities seems prudent.

In conclusion, we can see that all 4 discussions are interrelated and part of the moving parts – China weak growth momentum affects the global economic slowdown and causes further challenges. Russia’s invasion of Ukraine with related sanctions has contributed to continued supply disruptions, rising food scarcities, and energy concerns. Nevertheless, persistently high and broad-based Inflation is necessitating a tightening of monetary policies across the world among the major economies.

There is a lot of uncertainty and things can change rather quickly. Many of the gains from decades of globalization are being challenged and unfortunately are likely to be destroyed due to the growing global fragmentation. Many downside risks exist including a worsening energy crisis in Europe to further negatively impact growth and inflation. We have also been experiencing increasingly severe weather events that may continue to harm growth across the world.

Nonetheless, I will conclude on a positive note as there are always opportunities that emerge from crisis.

During contractions and challenges, we are placed on our heels. We are forced to be our best to survive. With the right mindset we can remain flexible, adaptable, and innovative. This is how new industries, sectors and leaders emerge. New ideas and better methods to overcome obstacles. Remaining liquid amidst tightening liquidity in order to seize these opportunities is key. It is about our perspective. We will survive and thrive as challenges always breed new opportunities with the right mindset. Let us seize these incoming opportunities as these are opportunistic times.