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Invariant Q2 2022 Letter: Part 2

Executive Summary

  • At Invariant, we believe the economy is much stronger than commonly believed. Volatile and persistently high inflation is making it difficult to ascertain what is really going on.

  • This explains the resilience in corporate earnings that has surprised many bearish analysts.

  • Barring another significant move higher in energy prices, inflation has likely peaked. If true, this is a significant development that will impact the trajectory of monetary policy moving forward.

  • We did a second round of significant tax-loss harvesting across portfolios. This included adding to two new ETF’s managed by Avantis Investors, AVUV and AVDV. These two holdings focus on companies that score well on profitability and valuation metrics, a theme Invariant believes in over the long run.


At the end of our Q2 commentary, we said “In this environment, it is extremely important to remain focused on what matters over the long term.” There, we focused on the big picture and how to think about portfolio volatility in the context of your financial plan.

In Part 2, we now focus on what we think are the most underappreciated dynamics of the economy and financial markets today. With the benefit of recent data, we analyze the underlying health of the economy, its impact on corporate earnings, and discuss our forecast for inflation moving forward.


Invariant is more optimistic on the U.S. economy and corporate earnings than most of our competitors. In our view, COVID marked the end of the 12-year post-global financial crisis "low growth, low inflation" economy. While every cycle is unique in its own ways, we think this time truly is different. It will pay to lean on principles rather than dogma, and nuanced thinking, rather than emotionally charged political or economic analysis.

In the second quarter, nominal GDP increased at a 7.8% annualized rate, from +6.6% in Q1. What's more: disposable income was UP 6.6%, compared to a decrease in the prior quarter. Not bad for an economy that is widely reported as being in a recession.

This would explain why most people are scratching their heads about the strength of Q2 earnings. Companies report in nominal terms, and two things are true: nominal economic growth is strong, and the balance sheet position of American consumers is extremely healthy.

According to estimates by Mark Zandi of Moody’s Analytics, excess savings post-COVID were $2.7 TRILLION, > 10% of GDP, distributed across all income groups. While economists are liable to get egg on their faces, his recent claim that, despite two consecutive quarters of negative real GDP growth, “This is not a recession. This is not even in the same universe as recession” seems right for now.

S&P 500 sales were up +12% year-over-year and are +17% higher than pre-pandemic (4Q19). Margins were up 10.9%, which is softer than the 13.5% in Q1 but still > 10.6% pre-pandemic.

In nominal terms, US Retail Sales are still strong, hitting another all-time high in July, up 3.6% over the last 6 months. After adjusting for inflation, the story changes. Real Retail Sales peaked in April 2021 & are down 1.1% over the last 6 months. But this is a mild pullback after extreme gains.

Supply chains are improving. This chart is from a highly regarded chief economist with good data on the supply chain. For the first time since the pandemic, his proprietary “supply chain health” indicator is back in positive territory.

You can see this in ocean freight rates and ISM manufacturing delivery times as well. Freight rates from China to LA have round-tripped their entire move higher the last 18 months, down ~50%. ISM delivery times (top line, next chart) have steadily improved from their worst levels at the end of last year, and Empire State Manufacturing Delivery Time is now back to where it was pre-pandemic.

The bottom line is things are much stronger under the surface than they appear. And if inflation has peaked (which we believe it has), real GDP could rebound strongly relative to expectations.


At Invariant, we do a lot of proprietary in-house research. We also have relationships with subject-matter experts either via our professional network, or third-party research services we pay for. There are two experts we currently defer to on matters of inflation: Warren Pies of 3Fourteen Research, and Omair Sharif of Inflation Insights.

Both of them made prescient calls about inflation being higher and more persistent than most thought possible coming into this year. And both are now pounding on the table that CPI has peaked, and is likely to come back down swiftly.

While they differ on the magnitude of the coming move lower in inflation, they are in agreement about two things: the direction is clearly down, and their forecasts are not contingent on a deep global recession.

The components that drive CPI shift over time. Sometimes housing costs are the dominant driver, sometimes it is automobiles, and right now it is energy:

Warren's report calling the peak in CPI was published back in June. Based on his detailed, bottoms-up forecast, he projected that CPI had peaked even if the price of WTI crude oil went to $160/barrel.

Since then, WTI and its cousin, RBOB gasoline futures, are both down nearly 20%. We remain intermediate-term bulls on oil, but if CPI had peaked even in a $160 crude scenario, how much more so is it poised to come down given the subsequent decline?


Although many of the issues economists and investors are concerned about are real and should not be dismissed out of hand, especially in the face of a global monetary tightening cycle, a deeper dive reveals an economy that is much stronger than headline numbers would suggest. All else equal, should inflation come down materially, as it looks poised to do, the rebound in real GDP could make heads spin.

The Russia/Ukraine conflict spiraling out of control, China waging war on Taiwan, an energy and food crisis leaving millions freezing and starving this winter in Europe, and growing political disenfranchisement growing violent in the US all pose risk to this forecast. While we do not claim to have a crystal ball, we are paid to take risk when we are compensated with outsized expected return. Should any or all of these situations unfold in a way that is “less bad” than expected and priced into markets, anxiety surrounding them will provide a giant “wall of worry” for stocks and bonds to climb for some time.

As ever, should data evolve in a way that reduces confidence in our thesis, we will humbly update our forecast and adjust portfolios accordingly.

Thank you for your trust and confidence,

David M. Borowsky

Chief Investment Officer


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