Recession whispers grow louder

Good morning. Unhedged is delighted to have won the 2021 best newsletter award from the Society for Advancing Business Editing and Writing. Many thanks to the Sabew judges for looking past all the typos.

It’s been a week of The Fed Scaring Everyone; we have a look at some recent recession talk below. Also, might ol’ Uncle Warren, by investing in HP, be repeating mistakes he made with IBM 10 years ago?

Email me: robert.armstrong

Recession talk

Bill Dudley, who used to be president of the New York Fed, wrote this in Bloomberg on Wednesday:

It’s hard to know how much the US Federal Reserve will need to do to get inflation under control. But one thing is certain: to be effective, it’ll have to inflict more losses on stock and bond investors than it has so far . . . 

As [Fed chair Jay Powell] put it in his March press conference: “Policy works through financial conditions. That’s how it reaches the real economy.”

He’s right . . . The US economy doesn’t respond directly to the level of short-term interest rates. Most home borrowers aren’t affected, because they have long-term, fixed-rate mortgages. And . . . many US households do hold a significant amount of their wealth in equities.

This is a bit of a buzzkill, but it articulates an important truth. Tightening monetary policy stops inflation by destroying jobs, lowering investment, and making people poorer. That doesn’t mean it’s not sometimes the best option. It is certainly the best option right now. But it is not, and cannot be, a costless process. Good on Dudley for his plain speaking.

He could have been still plainer, though. What sends stocks, in particular, into meaningful corrections is not tight monetary policy alone. Lately, every broker on Wall Street is publishing charts and tables showing that stocks do just fine in the first year or two of the Fed tightening cycles. What makes stocks correct is recessions. Or more precisely, meaningful corrections and recession correlate. Dudley is saying that the Fed will be forced to push the economy into a recession to stop inflation (and indeed, in other forums, he states this plainly). 

Dudley is not the only downer in the punditocracy this week. Also on Wednesday, Deutsche Bank became the first big bank to predict a recession. It’s head economist, David Folkerts-Landau, and head of economic research, Peter Hooper, wrote that the war in Ukraine has increased inflation, that inflation will force the Fed to increase the policy rate more aggressively — to 3.5 per cent or more, well higher than the market expects — and that this tightening will cause negative US growth in the second half of next year.

I’m not sure I’m in the Dudley/Deutsche camp. But very high inflation, lousy consumer sentiment, and high stock and house prices sure do look like a volatile combination.

The two most common arguments against impending recession are that consumer and corporate balance sheets are flush with cash, and that it is just plain weird to predict recession when the unemployment rate is at a historically low 3.6 per cent and falling. I think the first argument begs the question: a recession is nothing but a period when consumers and businesses would rather hold on to their cash than spend it.

I used to find the second argument quite compelling, until John Owen, an adviser at CIBC, pointed out to me that unemployment is a lagging indicator, and stays low right into the mouth of the recessionary wolf. Here’s the chart from the Fed, with recessions shaded:

I have a strong pessimistic bias that has put me in the wrong before. But just because you’re paranoid doesn’t mean the economy isn’t out to get you.

Berkshire buys HP

Berkshire Hathaway, as we recently noted, has been having a moment. Warren Buffett’s insurance/energy/railway/equity mutual fund mega-conglomerate thingy has been a mild but chronic underperformer for many years. But as the energy and insurance sectors have outperformed in 2022, Berkshire has beaten the market soundly. It has celebrated by buying a $4.2bn stake in the leading company in the overpriced printer cartridge industry.

HP also sells personal computers. But the printing division accounts for well over half of the company’s operating profits, and within that division, 60 per cent of revenues comes from ink cartridges. I have an HP printer. It works great, but when the ink runs out, which seems to happen quite often given how little I print, it costs me a fortune. This is annoying, but you have to admire the business model, which is the Gillette Mach 3, only more expensive. Yes, the cartridges cost too much; yes, I will continue to buy them; and yes, pre-tax margins in HP’s printing division seem likely to stay at a comfortable 18 per cent or so.

Which brings us to IBM. Buffett bought a $10bn-ish stake in Big Blue in 2011, when its stock was about $170. By the time Berkshire fully exited its position in early 2018, the stock was about $140. This bad investment was annoying/brilliant in exactly the same way HP’s core business is.

Buffett went on CNBC when he first bought IBM and said that “it’s a company that helps IT departments do their job better . . . is a big deal for a big company to change auditors, change law firms”, and companies’ IT departments have the same durable relationships with IBM’s consulting business. “There’s a fair amount of presumption in many places that if you’re with IBM, you stay with them.”

There is another way to make Buffett’s point: once you get IBM into your company, it’s nearly impossible to get rid of it.

Another similarity: Buffett went out of his way to praise the way IBM deployed its profits. The following brief sermon comes from Berkshire’s 2011 annual report:

Today, IBM has 1.16bn shares outstanding, of which we own about 63.9mn or 5.5 per cent. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. The company will probably spend $50bn or so in those years to repurchase shares. Our quiz for the day: what should a long-term shareholder, such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years . . . 

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance . . . 

In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity.

Buffett was dead right in that last paragraph. The success of the IBM investments was largely determined by its future earnings. They stank. Between 2011 and 2018 net earnings at IBM went from $15.9bn to $8.7bn. IBM’s businesses didn’t prove as sticky as they appeared. And it is fair to wonder how much of this had to do with the decision to prioritise buybacks over investment in those businesses.

And what does HP do with its profits? Well, in the past two fiscal years, it bought back $9.3bn of its own shares, which is more than a fifth of its current market cap. Following Buffett’s IBM logic, if that keeps up, Berkshire will be HP’s sole shareholder by 2027, and sooner if its share price tanks.

As a value guy myself, I see the appeal of IBM. Berkshire bought the company at a cheap forward price/earnings ratio of about eight, and it increased revenues at a meaty 12 per cent last year. That’s a rare combination. But the parallels with IBM — purportedly sticky last-generation technology, buybacks rather than investment — are unsettling.

One good read

Black Lives Matter bought a very expensive house. Great reporting from Sean Campbell.