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Welcome back. I was bitterly disappointed by the relatively low level of online abuse I took for my criticism of bitcoin ETFs on Wednesday. Are crypto fans growing soft in their old age? Or are they just rich and magnanimous now? In any case, Unhedged is on to a more important topic today: the economy and stocks. Email me: [email protected]
Earnings call the tune, stocks dance
Here are some things that are happening right now:
Inflation expectations are really starting to move. If you are of a mind to believe what the bond market is telling us, inflation is taking hold. Ten-year break-even inflation expectations — that is, 10-year nominal bond yields minus the yields on their inflation-protected brethren — are at eight-year highs, at 2.6 per cent. Five-year break-evens are at 16-year highs, at 2.8 per cent.
Oil has passed through $80 and is pressing higher. Traditionally, the stock market does not love it when oil goes on a tear (see: 1970s, 2000, 2008, 2018)
US growth continues to slow. Here’s my favourite one-chart indicator, the Atlanta Fed’s GDPNow estimate for the current quarter. Look at the change in the (data driven, non-discretionary) estimate just since September. In a word: ick.
The Federal Reserve’s Beige Book commentary from Wednesday is saying this (dreary words italicised by me):
Economic activity grew at a modest to moderate rate, according to the majority of Federal Reserve districts. Several districts noted, however, that the pace of growth slowed this period, constrained by supply chain disruptions, labour shortages, and uncertainty around the Delta variant of Covid-19 . . .
Growth in non-manufacturing activity ranged from slight to moderate for most districts. Loan demand was generally reported as flat to modest this period . . .
Most districts reported significantly elevated prices, fuelled by rising demand for goods and raw materials. Reports of input cost increases were widespread across industry sectors, driven by product scarcity resulting from supply chain bottlenecks. Price pressures also arose from increased transportation and labour constraints as well as commodity shortages.
Meanwhile, in the world’s other big economy, China, gross domestic product increased by 0.2 per cent between the second and third quarters (data via Bloomberg):
Now, none of this is end-of-the-world stuff. A lot of it may be Delta variant/supply bottleneck phenomena that will pass sometime next year. Indeed, that’s what it seems like most people think it is, and they have sensible reasons for thinking this. But the simple fact is that lately there is more inflation and less growth in the US and globally, for that matter. This is what’s happening now, whatever we may think or hope is going to happen next.
But what does the US stock market say? It says none of it matters. The dip has been bought. The S&P 500 is back to all-time highs, and the Nasdaq is close to its record.
What’s more, this might make sense. When you buy stocks you are not buying the world economy. You are buying company earnings. And judging by the small sample of third-quarter earnings reports we have seen so far, the earnings power of companies is holding up well.
The biggest American companies that have reported are the banks. While their results leaned a little too heavily on investment banking for my taste, and I do wonder what will happen to their credit card businesses if everyone keeps sensibly paying their balances, they had encouraging things to say about spending.
At Bank of America, credit and debit card spending rose 21 per cent, at JPMorgan it was up 26 per cent, and spending on Citigroup cards rose 20 per cent. Whatever else is going on in the global economy, the US consumer is feeling flush (why else would so many of them feel able to quit their jobs)?
A perfect example of a company flexing its earnings muscles despite everything is Nestlé. It is not a US company, which makes it slightly odd to mention in this context, but its results are nonetheless very informative: it sells basically everywhere, has employees everywhere, and it sources raw materials from everywhere. And its third-quarter results were amazingly good. It reported 6 per cent growth in sales volumes globally (and about the same level in North America) for the first nine months of the year, and nudged its full-year sales forecast up. It was able to raise prices by 2 per cent in the third quarter, and its operating margin outlook remains in line with recent years, despite input and shipping cost increases.
Nestlé, it should be said, is probably the best-run consumer products company in the world. It is ruthless about changing its product portfolio so it only stays in businesses where it can grow, earn good returns, and protect prices. Here is a chart of its operating margins and free cash/sales ratio since 1994. This amazes me:
So not every company will manage its way through this period the way Nestlé has. But it shows what a company that has global scale and a good competitive position can do. And Nestlé has not been alone. Procter & Gamble, for example, reported slightly less impressive organic sales growth, but it, too, has been able to raise prices.
There is a lot of earnings season left to go, of course, and we will hear from more than big banks and global consumer goods companies. But ominous pre-earnings guidance cuts have been notably rare. Among large companies, Nike’s struggles with its Asian supply chains, resulting in a cut to its sales outlook, looks like an outlier so far.
It may be that smaller companies, lacking the muscle of a Nestlé, may struggle more in the face of supply bottlenecks, and I think some retailers in particular are likely to struggle (remember Bed Bath & Beyond). Whether there is a bifurcation in results between big companies and small will be one of the most interesting trends to watch. And because valuations are high, the companies that slip can expect the market to slap them down hard.
But big companies that can manage around supply chain disruptions, and have pricing power, may earn their way right through this economic rough patch, if it doesn’t last too long. And that, in turn, might be enough to support US stock prices at their current dizzy levels, given the lack of attractive alternatives for investors.
One good read
We have heard a lot of speculation about how the end of central bank bond buying is going to be messy, however delicately the central bankers try to handle it. Well, it appears that the first large developed country to try it will be the UK. This summary of the rather nerve-racking situation by my colleague Tommy Stubbington is worth reading if you have not been following the story.