Better Than Feared
By Crest Capital Advisors on July 21, 2023
Dow: 2.08% to 35,227.69
S&P 500: 0.69% to 4,536.34
Nasdaq: (0.57%) to 14,032.81
Russell 2000: 1.51% to 1,960.26
10-Year Yield: 3.83%
Outperformers: Energy 3.53%, Healthcare 3.46%, Financials 2.95%, Utilities 2.40%
Underperformers: Communication Services (3.01%), Consumer Disc. (2.28%)
US equities were mostly higher this week with the S&P 500 posting its fourth weekly gain in the past five weeks and the Dow capping off a 10th straight daily gain on Friday. The Nasdaq Composite, by far the big winner over the course of 2023, was modestly lower on the week.
Supporting the ongoing market rally, economic data this week also offered more soft-landing evidence. June headline retail sales were a bit softer, but May was revised higher, and control group sales were hotter than expected in the latest signal around consumer resilience. July builder confidence also rose for a seventh-straight month to the highest level since June of last year. June housing starts and permits both came in below consensus, though analysts noted some demand signaling from single family starts still near the highest pace in a year and single family permits the highest since June 2022. Initial jobless claims came in at 228k, below consensus for 241k and the lowest weekly reading since May.
Overall, there were a number of moving pieces this week but corporate earnings were by far the big story. And on this front, the big surprise was how banks in particular managed to post strong results and better than feared deposit data despite the troubles that plagued the banking system in late March and into April/May. Once again, we see a set-up developing around earnings season whereby pessimistic analyst expectations manage to set a fairly low bar that corporations have become extremely adept at stepping over.
About That Delayed Recession
Since the Federal Reserve began aggressively hiking interest rates last year, we’ve heard nothing but calls for a recession by economists and Wall Street strategists alike. But this ‘most anticipated’ recession ever has still not arrived, and there’s no obvious sign a recession is near even after previously reliable indicators like the inverted yield curve have flashed red flags for an extended period of time.
According to a recent report from Albert Edwards, global strategist for French investment bank Societe Generale, “something very strange has happened” that explains why a US recession has been delayed, and it has to do with some very timely moves made by corporations. In this report, he highlighted that going back to at least 1975, corporate net interest payments would typically rise as the Fed raised interest rates. But for the first time in a long time, that isn’t happening. Instead, as the Fed raised rates over the past 15 months, corporate net interest payments actually fell. (See chart below)
Interest payments are actually down as rates have risen because corporations took advantage of low rates during COVID and long term financed 76% of their debt. Usually, the exact opposite happens. But today, only 6% of all corporate debt is considered short term financing. So as revenues rose during this recent bout of inflation, corporate costs really didn’t go up commensurately along with it, thereby expanding profit margins.
To simplify, corporations basically did the same thing that homeowners did…refinanced their debt during COVID at record low rates. So essentially the Fed rate hikes aren’t doing the usual job to slow down the economy. We think this may be what the stock market has caught onto and why markets are climbing despite the ongoing doomsaying around imminent recessions. The bottom line is it might take a much longer period of time for the economy to slow. Yes, eventually debt will have to be refinanced but it’s way further out than it usually is this time as corporations smartly took advantage of long-term financing.
“Normally when interest rates rise, so too do net debt payments, squeezing profit margins and slowing the economy. But not this time.”
Supporting these conclusions, and according to data from Bank of America earlier this year, companies bought themselves some time to navigate higher rates. As noted above, the debt composition of S&P 500 companies includes just 6% in short-term floating rate debt, just 8% in long-term floating rate debt, 10% in short-term fixed debt, and a whopping 76% in long-term fixed debt.
This “helps explain the recession’s tardiness,” SocGen’s Edwards said, highlighting that net interest payments have fallen 25% at a time when they would have risen sharply based on history.
“Companies have effectively played the yield curve in reverse and become net beneficiaries of higher rates, adding 5% to profits over the last year instead of deducting 10%+ from profits as usual.”
The lack of a profit decline means companies didn’t have to resort to a big wave of layoffs that would have dented the economy and thrown it into a recession. The low-rate, long-term debt held by corporations, combined with their pricing power during a time of elevated inflation, means most businesses were able to grow profits in a big way.
“Interest rates simply aren’t working as they once did. It is indeed a mad, mad world.”
All of this could change if companies have to refinance their debt at higher rates. But with most of their debts not maturing until 2025, 2026, 2027, and beyond, it’s possible that interest rates could move lower between now and then, enabling companies to continue to ride the coattails of low rates and ultimately stave off a recession completely. This would sure send the bears back into their caves for a lengthy period of hibernation!
Wage Gains
We found out this week that Inflation-adjusted average hourly wages rose 1.2% in June from a year earlier, according to the Labor Department. This marks the 2nd straight month of seasonally adjusted gains after two years when workers’ historically elevated raises were erased by price increases. If the trend persists, it gives Americans leeway to propel the economy through increased spending, which could help the US skirt a recession. That’s the good news.
But, it may not be good news for investors who want to see the Fed take it’s foot off the gas pedal of rate hikes. After all, this Jerome Powell led Fed seems to place an outsized emphasis on the mistaken belief that higher wages lead to higher inflation (it’s the other way around!). So, despite 2+ years of wage lagging inflation, we’ll have to watch for any renewed focus on these metrics and what they could mean for the fed funds rate in the months ahead.
Survey Says
The latest version of the Bank of America Global Fund Manager Survey is out and as usual, there are some interesting data points to review. We took particular interest in the noted increase of those managers anticipating a “soft landing”, with more than 2/3 (68%) of fund managers now seeing just a modest slowdown rather than a full blow recession.
And yet, despite this growing optimism in terms of the economic outlook, the most overweight area from an asset allocation perspective is cash!? With equities as the most underweight category?! This significant disconnect from the economic outlook to actual portfolio positioning tells us that there is perhaps quite a bit of additional upside potential in this market IF money managers decide to start putting their money where their mouths are. Or perhaps fund managers are just as bad as two-handed economists?
Economic Funnies
In honor of Q2 earnings season entering peak reporting week…
Crazy Stat(s) of the Week
Here are this week(s) crazy stats!
- The Dow Jones Industrial Average just completed its first 10 day winning streak since August 2017. It’s worth noting, the past 9 times it was up even 9 days in a row, stocks were higher a year later every time. Going back to WW2, they were up 85.7% of the time a year later.
- US Federal Tax receipts fell 7% over the last year, the largest year-over-year decline since June 2020 and before that April 2010. At the same time, US Government Spending increased 14% over the last year. The Result: A budget deficit of $2.25 trillion! Surprise, surprise.
- The gap between the 10-year Treasury and the 3-month Treasury is now reflecting the largest yield curve inversion in more than 40 years! And yet the Fed still insists that financial conditions may not be tight enough to get inflation back to their 2% target.
Quote(s) of the Week
“When an investor focuses on short-term investments, he or she is observing the variability of the portfolio, not the returns – in short, being fooled by randomness.”
-Nassim Nicholas Taleb
Calendar of Events to Watch for the Week of July 24th
Following a second week of Q2 earnings season, ~17.5% of the S&P 500 has now reported. According to FactSet, 75% of reporters have beat expectations, while earnings are surprising to the upside by ~6.5% in aggregate. Earnings will once again highlight next week’s news flow with one of the busiest weeks of the season on tap.
But, as to the main event next week, all eyes will be focused on Wednesday’s FOMC meeting where the market continues to price in a ~99% chance of yet another 25 bp hike. (Editor’s Note: They absolutely should NOT hike…but with futures markets already pricing it in, effectively giving it to the Fed, we doubt they will be able to overcome the temptation to “take it”.) Perhaps it will come with a healthy dose of dovish talking points so market participants can come away with absurd conclusions such as…”that was a dovish hike”!
On the economic front, we’ll also get data readings on Flash Manufacturing/Services on Monday; Durable Orders, Wholesale Inventories, GDP, and Weekly Jobless Claims on Thursday; and wrap the week with two major inflation reports…the Personal Consumption Expenditure (PCE), and the Employment Cost Index.
Monday 7/24 – The Markit PMI Survey Results (preliminary) for July Manufacturing and Services will both be released shortly after the market open. Manufacturing is expected to remain in contraction at 46.0, down from 46.3 last month and Services are anticipated to remain in expansion at 53.5, down a bit from last month’s 54.4 level.
Tuesday 7/25 – The Case-Shiller Home price composite for May is expected to decline by -1.8%. July Consumer Confidence is expected to be roughly inline with last month at 110.0 v. 109.7.
Wednesday 7/26 – The main event today will be the conclusion of the latest Federal Reserve meeting and subsequent press conference. While futures markets are ready to accept yet another rate hike of ¼ percent, we think the Fed should remain on hold.
Thursday 7/27 – US Q2 GDP will be out with economists expecting a 2.0% year-over-year rate and 1.4% quarter-over-quarter. US June Durable Goods data is expected to contract -1.0% and Wholesale Inventories are also expected to contract by -0.10%.
Friday 7/28 – Big day for inflation with the Fed’s favored measure of inflation, the Personal Consumption Expenditure (PCE) index due out. Economists are projecting a headline rate of 3.0%, down substantially from 3.8% last month. The Core however is expected to remain a bit more elevated at 4.2%, down from 4.6%. We’ll also get the BLS’s Q2 Employment Cost Index (ECI) which is forecast to come in unchanged at 4.8% year-over-year.
Source: FactSet
