Why a US recession is unlikely

I’m Staci from FundCalibre, and today I’m joined by Hugh Grieves, co-manager of the Premier Miton US Opportunities fund. Hugh, thanks for joining me today.

[00:10] Thank you very much.

So, we’ll jump right in. What are your thoughts on the US economy and the environment for companies amongst interest rates, inflation and the possibility of a recession?

[00:23] I think it’s really interesting because if you look back to last year, when everyone was first calling for a recession, you know, we had Russia walking into Ukraine, we had energy prices going through the roof, we had Europe on their knees, we had inflation going sky high, the Fed was going to tighten, the housing market was going to crash, and government spending was going to be this big headwind to the economy for the whole of last year. 

And you know, here we are a year later, and energy prices are lower than they were a year ago, Europe is in reasonable shape, US unemployment is basically flat with where it was a year ago, and the housing market’s still intact, and government spending is actually accelerating above where it was a year ago. 

But we’re still here talking about recession, and I think people have really mis-underestimated – if that’s a word – the momentum within the US economy, and the fact that we’re starting from a position where the US consumer has got plenty of cash, jobs are plentiful, wages are rising, debt is low. Usually when you get to the end of an economic cycle, none of those are true. Usually, you’ve got the consumers maxed out their credit cards and spent all their cash, and then the Fed comes along the raises rates and tips the economy over into recession. So, I think recession really is pretty unlikely from where we are today. 

And, in terms of interest rates and inflation, I mean inflation clearly has peaked and it’s coming down gradually. The Fed looks like it’s going to peak raising rates. The big question becomes, where is inflation going to level out to, right? So, the Fed has got this target that inflation is going to be 2%, it set that target along with other central banks a long time ago. But unfortunately, it’s a pretty unrealistic target in the world that we’re in today. And I think the Fed is going to have to accept that inflation is going to be close to 3% or maybe high 3s. And then once the Fed has accepted that, you know, I think we’re going to be living in a very different world. It’s going to be a world of higher interest rates, higher nominal growth and higher inflation. But what that means for investors is, in this new environment, I think you will have to look at very different asset classes to do well going forward from here.

Well, you’ve said before that it’s best to invest in small caps in the depth of a recession. So, why is this? Should investors wait until things get worse? Does this still hold true?

[02:47] So, I mean, it’s really interesting because when markets start worrying about recession, you know, the classic thing that happens is people gravitate towards larger companies and they sell smaller companies because they’re perceived to be more cyclical, more risky, worse balance sheets, et cetera. And, you know, there’s a safety – especially in the US – of owning these big mega cap tech stocks which have, you know, high margins, good balance sheets, and very strong competitive moats. 

And that’s very much what you saw happen in March of this year, when Silicon Valley Bank went under, [also] Signature Bank, First Republic, and we had all these issues and suddenly everyone was worrying. It’s like, oh my goodness, it’s going to be 2008, this is Lehmans, this is Bear Stearns, this is the Global Financial Crisis all over again. And, from that moment, we saw this massive divergence within the US market where everyone moved up the market cap scale into the very largest companies, and we saw this pretty indiscriminate selling amongst small and midcaps. 

So, where we are today is, you know, people are still calling for a recession, the mega caps look really, really expensive, but a lot of people that are investing in those types of companies and are now starting to look at the mid and small caps thinking, well, if we’re not going to get a recession, these companies are looking really cheap. And I think that’s a big opportunity here, is that these companies have a priced for a recession, and if that recession isn’t going to actually happen, then investors have a significant opportunity.

And the US debt ceiling has been making headlines recently. So, maybe just for our viewers, what is this all about? How does it impact companies and ultimately investors?

[04:26] Right, there’s two different areas. One is, is the US going to default on its debt? Because once the US government has reached the limit of how much debt it can issue, then the danger is that it can’t service or can’t pay the interest on its existing debt. And that’s how you get to a default, and that’s what would trigger this sort of financial armageddon. Now, we’ve moved through that, and you know, as was widely expected, everyone thought it was going to happen, but it was always in the back of everybody’s mind; it’s like, well what if, right? What if it doesn’t happen? Do we face this huge risk? 

Now, it hasn’t happened, and we’ve moved on, but some of the hangovers, well some of the hangover remains with us because to keep the government operating, the US Treasury basically does the equivalent of looking behind the sofa and finding all the pennies that it can spend, to try and keep the government afloat. The impact of that is it runs down the amount of cash that the government itself holds out into the economy, which boosts liquidity, and some of that money leaks into the stock market, to push up asset prices. 

Where we are now, is the government is trying to replenish the coffers and it’s going to start issuing hundreds of billions of dollars’ worth of debt. And the worry is that that money then gets sucked out of the stock market into the government’s bank account. And the very stocks that did well going into the debt crisis will be the ones that do the worst coming this side of it. 

So, that’s what we’re watching at the moment. And I would imagine that the US Treasury is being very careful in how it issues all this debt, but at the end of the day, the money’s got to come from somewhere. And the danger is that this liquidity that’s taken out of the US market could hurt some of the highest beta, most volatile, most popular names that there are on the market.

And I just want to finish on the fund because this isn’t your typical US fund. I think I recognised one holding in your top 10 and I like to think I’m well versed in US companies. So, to finish, maybe just tell us what are you looking for in a company that makes this portfolio ultimately so unique? And then maybe just pick on one holding in the portfolio today to kind of demonstrate.

[06:40] So, we look for dull and boring companies that can predictably and consistently compound earnings year after year. We are not looking for companies that can try and change the world. And one example that we have, which is a company called Watsco [, Inc.]. Now, we’ve held it for coming up for 10, it’ll be 10 years next month we’ve held the stock. It is the largest distributor of air conditioning parts and supplies to contractors. And what’s great about the air conditioning business is that, you know, your air conditioning, it doesn’t break in the middle of winter: it breaks in the summer when you really need it, so, you don’t have an option, you’ve got to change it. And, over the years, due to efficiency requirements [and] energy requirements, the cost of these systems gradually creeps up every year; population growth increases the number of air conditioning units out there, migration in the US from the coolest north to the hotter south increases demand further.

And then Watsco gathers a little bit of market share every year, they buy back shares and, as a result, they’ve got this fantastic track record that they’ve been able to compound earnings at 18% per year on average for 30 years. And it’s one of the top performing stocks over the last 30 years in the US market. And it does it, not by writing software, not by supplying jazzy consumer electronics or semiconductors, it does it by supplying air conditioning parts. And that’s the perfect dull and boring business that we try and find. And when we’ve found it, we don’t sell it, we hang onto it.

Well, I think quite a few of our listeners in the UK wish they probably had some AC this week with the heat, but I can attest AC is definitely something you want fixed in America pretty much no matter where you live, <laugh> so, that’s a great example. Thank you. 

And thank you for taking time just to talk to us about the US economy and talk us through some of the headlines that we’ve seen recently. It’s very much appreciated. 

[08:38] It’s a pleasure. 

If you’d like to learn more about the Premier Miton US Opportunities fund, please visit FundCalibre.com. And don’t forget to like and subscribe for weekly videos.