No Shortage of Souring Sentiment

Hear the one about supply chain bottlenecks knocking global growth, threatening the economic recovery from lockdowns? The International Monetary Fund (IMF) did—and ratcheted down its projection for developed-world growth this year from 5.6% to 5.2%.^[i] So did the people surveyed by Germany’s ZEW Institute, whose measure of German investor confidence slipped to its lowest level since COVID panic set in last year.^[ii] And the US small business owners surveyed by the National Federation of Independent Business, whose sentiment measure fell again in September.^[iii] And US CEOs surveyed by The Conference Board—their confidence level slipped almost -20% in Q3 on, you guessed it, supply issues.^[iv] This all comes on the heels of The Conference Board’s broad US consumer confidence measure sinking to a seven-month low in August.^[v] Many financial commentators we follow are treating these increasingly dour sentiment readings as portending to weak economic activity ahead in a self-fulfilling economic prophecy. We think that is a stretch. To us, these surveys and projections show the state of sentiment—and what equity markets have likely priced in—extending the proverbial wall of worry for equities to climb in the process.

We do think it is fair to say all those who cite supply shortages as an economic headwind are on to something. Whilst strong demand and overflowing order books are great, at the end of the day, output and spending are what show up in flagship economic statistics. If businesses can’t get the supplies they need, they can’t make their widgets, and output drops. If they can’t get finished widgets to customers in a timely fashion, then sales likely drop. Both can weigh on industrial production, retail sales, gross domestic product (GDP, a government-produced measure of economic output) and other hard data.

Thing is, our research shows equities don’t have a one-to-one relationship with any economic statistic. In our view, they don’t need growth to be fast or even particularly good. Just ok and not so bad are quite fine outcomes, based on our research, if investors’ general expectations are low enough. We think this is because equity markets move not on absolute reality, but the gap between reality and expectations. The lower expectations become, the easier it theoretically becomes for reality to beat them, even if reality is not so wonderful.

All these sentiment surveys, along with the IMF’s revised forecast, demonstrate that the prevailing expectation globally is for supply chain problems to take a bite out of growth, slowing the recovery. In our view, it is quite fair to presume markets have priced in this viewpoint, as our research shows (and generally accepted financial theory holds) that they deal efficiently with all widely known information. That includes opinions, fears and forecasts (which we would also classify as opinions). What will likely drive share prices over the foreseeable future, then, is how economic reality squares with expectations. If things go exactly as people fear, it likely won’t be a huge deal to equity markets, as they probably will have already priced in that reality. If things go even a smidge better, that should theoretically generate a positive surprise.

We suggest not discounting the chances of that happening. In our view, sentiment surveys aren’t predictive—they tell you how people feel today, which we think is generally a product of what they hear and read. People who hear endlessly that supply chain snarls are tying up the global economy are more likely to tell surveyors they expect bottlenecks to be a big economic risk. Surveys both reflect and amplify headline sentiment, creating a negative feedback loop. Meanwhile, what we have found gets less attention are the anecdotes about companies chartering their own ships, finding ways to transport goods across the sea without traditional containers, and cutting nonessential costs to preserve profits without raising prices.^[vi] We have found incremental workarounds are often the seeds for incremental positive surprise.

Another key consideration that we think gets lost in most of the supply chain coverage: It doesn’t affect all industries equally. Software and digital services, for instance, are relatively insulated. So are companies which have much fatter profit margins than the market as a whole, known as growth-orientated companies. Not only can companies with wide profit margins self-finance workarounds (as well as future growth), but they can also stomach cost pressures more easily than companies operating on a shoestring. In our view, far from being a market-wide negative, supply chain issues are likely a big reason for growth-orientated shares’ big outperformance since May.^[vii]

If things go far worse than everyone anticipates, then it could prove problematic for shares. We don’t dismiss that possibility, either. But our research shows markets move on probabilities, not possibilities. Shortages of components and raw materials have already prompted many suppliers to ramp up, according to all the industry news we have reviewed over the past few months, which suggests this issue is likely to resolve sooner rather than later. That could change, but in our view, the most probable scenario is that supply shortages create winners and losers, not a deep, lasting equity market downturn.