Apollo CEO Marc Rowan qualified the current economic climate by saying we may experience a “non-recession” recession. This was one of the more interesting recent descriptions of the rolling fight against inflation and the impact of higher rates. “Those in financial markets, you’re going to feel a recession. That’s what I mean by a non-recession recession. I just don’t see any sign of the underlying economy of the kind of demand destruction that is going to put employment, unemployment, excuse me, back to levels we would think about as recessionary.”
Marc is right in that the underlying economy remains strong. This week saw Q1 GDP revised up from an annualized 1.3% to 2.0%. Downward revisions, the opposite, are typically what you see into a recession. There are several items lurking that could still tip the economy into recession and constrain consumption, including high personal debt levels and extended housing costs. The most important and underreported of these may be the resumption of student loan payments in the fall, which are greater than the average monthly savings for many Americans. Adding a debt servicing cost that eclipses the disposable income for many families can only be negative. The results of this won’t show up for several months, though. In the meantime, you may see managers aiming to hedge their portfolios for an economy that remains strong.
In an inflationary environment, the ideal investment is one where the company can increase prices faster than costs. Tech stocks have performed well against these requirements as layoffs, combined with some real and predicted AI efficiencies, let them control costs better than other companies. The potential for inflation being beaten and rates declining further boosts tech stocks, given their longer duration. Energy companies have also historically been a go-to investment under these criteria, especially if inflation becomes more unpredictable and sticks around.
Other dynamics may support an energy allocation. From a timing perspective, there are the added tailwinds of SPR releases finishing and OPEC cuts starting to hit storage numbers. For commoditized industries, you also typically want a period of more barriers to growth, and the higher rates of the last year are one. Oil and gas have returned their cost of capital over the long run, and higher rates typically portend a period of higher returns. The contrast was the low rates early shale era, where minimal barriers to investment led to poor returns and even helped cap inflationary risks for the broader economy. ESG is also serving this role by preventing investment and projects even beyond the capital cost restrictions. This likely isn’t great for the fight against inflation, as cheap, abundant energy is the friend of any economy, but it is the current dynamic.
Certain energy companies may even be better positioned to control their costs from inflation, specifically the oilsands in Canada. This is because costs were front-loaded, with lower maintenance costs thereafter. With largely spent costs and revenues increasing due to the dynamics above, these and other energy companies may become a natural inflation hedge. The sector outperformed the last several days of Q2, and it will be interesting to see if managers are increasing their allocation with similar themes in mind.
