Dr. Adrian Cronje, CFA
Capital Markets Lead the Economy
Every CEO should be aware that capital markets lead the economy, not the other way around. Traditional economic forecasting is quite limiting when predicting the future – especially downturns over a time frame that is useful, like 12 to 18 months, for business owners to adapt their strategic plans and pivot. Relying on economists and strategists to divine the future is like driving a car by looking in the rear-view mirror.
Four key capital markets are leading the economy that you should monitor closely, using them in conjunction with one another:
- Stock market – future corporate profitability
- Bond market – future interest rates and Federal Reserve policy
- Credit market – optimism in the corporate sector
- Commodity market – international economy (especially China)
Capital Market Messages
While headline stock market indices appear to have escaped the bear they first entered in the summer of 2022, performance has been driven by a concentrated handful of stocks. The average stock has actually not advanced by much over the last year. Still, corporate profitability has held up better than many anticipated in the face of a significant period of interest rate increases.
The signal from the bond market has remained consistently pessimistic however, with the yield curve remaining inverted since the summer of last year. The bank lending channel plays an important role in our economy, with the ability of banks to make profits by taking deposits short and lending long. Regarding yield curves in the bond market, an inverted curve is typically an indicator of an upcoming recession in that it creates a headwind to banks’ profitability and willingness to lend.
The credit market, or the market for corporate bonds, tells us about corporate America’s ability to finance itself outside of the traditional banking channel. High yield (or lower quality corporations) over the long haul have to finance themselves with premium on average of 500 basis points (bps) over equivalent Treasury bonds to entice investors. Once that spread rises above 500bps, the corporate bond market is saying we are in the beginning of a slow-down or approaching a recession as they are anticipating greater defaults. The corporate bond market spread had remained tight, within 500bps, signaling a more optimistic outlook than the bond market.
Commodity markets tell a great deal about the health of a global economy. Unlike when the Great Recession started in 2008, the U.S. no longer produces a majority of global GDP, even if it is still the largest economy in the world today. In aggregate, Brazil, Russia, India and especially China produce a much more significant percentage of global GDP today than before, both producing and consuming commodities at an astonishing rate. Therefore, buoyant commodity markets are sign of health for their economies. In saying this, be careful to parse out gold and silver (commodities that act more like a currency) from broader commodity complex, such as copper, iron ore and nickel – these are the things that drive industrial production. Commodity prices have not made material gains over the last year, speaking to weakness in economic growth in international economies.
Overall, the capital markets are sending mixed signals about the future economic outlook. While the credit market is most optimistic, the bond market is the most pessimistic. It remains unlikely that the economy will adjust to a new era of more expensive and less abundant capital without at least a short and shallow recession. So far a very strong labor market, where labor demand has far exceeded labor supply, has stood between the current muddle-through economy and an officially dated recession, though cracks are starting to appear with the unemployment rate finally ticking up.
Prepare to Be a Predator, Not Prey
- The COVID-19 pandemic forced adaptability, but don’t wait for another recession or pandemic to be prepared.
- Improve your agility for decision-making and creativity to optimize organizational risk exposure.
- Supply chain management is important to your resiliency. Move from a mindset of “just in time” to “just in case.”
- Improve the process of turning inventories to cash flow.
- Value creation comes not from multiple expansions but from recurring revenue and underlying pricing power.
- Observe and embrace the “tech-celeration,” e.g., e-commerce, digitization,
on-demand business models, automation, artificial intelligence, blockchain protocol, and virtual communication - Keep in mind that the cost of capital has increased when engaging in mergers and acquisitions.
- Adapt to new buying behaviors of your customers in a post pandemic world.
- Implement your marketing and sales to accommodate a virtual world – data on client and prospect engagement is valuable.
- Hiring and retaining talent is more than just what you pay. Culture and the work environment is more important.
- Re-imagine your operations with new technology in the workplace.
- Improve your balance sheet strength and free cash flow.
- Improve pricing power and strategy with inflation as a tailwind.
First Generation Wealth
Balentine works with entrepreneurs, and as entrepreneurs ourselves, we’ve learned a lot about not just how to run and scale a business, but the implications within your family and the many transitions business owners face. That’s why we have released a book to help entrepreneurs sort through what you should be asking yourself and exploring to set yourself and your family up for success. Being so immersed in day-to-day business affairs often prevents entrepreneurs from anticipating and preparing for the many forks in the road of their entrepreneurial and life journeys. The purpose of this book is to uncover the questions they need to ask themselves throughout their journey so that they can stay in control of their own destinies, shape their legacies, pass on the fruits of their labor and, perhaps most importantly, live lives of fulfillment and meaning. Our cardinal rule is, “Your greatest asset has nothing to do with money,” is explored in depth in this book. You can learn more about the book at firstgenerationwealth.com.
Conclusion
The Economy:
- There will likely be a bumpy transition (short and shallow recession) to a new healthier era of higher interest and scarce capital.
- The labor market remains the biggest bottleneck.
- Inflation expectations remain anchored for now.
Your Business:
- Always prepare to be a predator, not prey.
- Value creation not from multiple expansions, but from recurring revenue streams and underlying pricing power.
- The cost of capital for M&A has increased.
Your Legacy:
- Don’t mistake wealth for legacy.
- Distinguish between your business and the business of your family.
- See the world through the next generation’s eyes.
