MACRO
Macro picture is still focused on inflationary pressures and slowing growth as the estimate of US GDP growth was revised down from 2.4% to 2.1% for Q2 23.
On the supply side there are many inputs which cannot be directly impacted by fiscal or monetary policymakers. So far this year we had unwinding of some of the the supply shocks from the pandemic era. Supply bottle necks have been partially resolved, but there are many secular pressures related to supply chain decoupling which increase costs of international business.
In addition US labor market remains tight, with increasing payroll numbers. Below payroll data from BLS for this year.
Employment by industry, January-August 2023, seasonally adjusted
In addition we have a wage pressures coming from ‘The United Auto Workers’ (145,000 members demanding 20% immediate increase and 46% increase over 4-years), and other unions which keeps on adding to the inflationary pressures.
Another topic is housing. S&P Case-Shiller Home Price Index rose in June to close to all-time high, explained mostly by inventory pressures. Homeowners are locked to their existing homes through fixed cheap loans, which they would be force to refinance at over 7% rates if they decide to sell and move to new house. Current supply-demand imbalance keeps prices close to historic highs despite valuation pressure.
It should be also reminded that the overall debt levels in the US are becoming a greater concern at the current interest rates level. US has now reached levels of $32t in public debt, $17t household debt, $1.5t student loans debt, $1t credit card debt. Increased costs of debt servicing will quickly become a major drag on the economy.
RATES
For the full year now market is trying to figure out where the FED is in the cycle. During that time market changed its opinion many times, yields remaining volatile and the yield curve haven’t found the equilibrium yet. The ICE BofA MOVE Index, which tracks fixed income market volatility, remains elevated above 100 points for 18 months now (compare to 40-70 level during less volatile periods).
From the technical perspective rates are extremely oversold. They are holding key technical levels and have a room to rally. With the wage pressures coming from the unions, and being also visible in the service sector, there is a still space for the FED for one more hike later this year.
People in the camp of soft lending, should be positioning themselves for the ‘steepener’ in order to capture gains from potential reversal of the yield curve inversion.
CREDIT
High rates keep a pressure on banks, which holds large unrealized losses on their balance sheets. Their lending business has also been eaten away by very aggressive competitors in the private credit space, which keeps on expanding their book, while banks have been tightening their lending conditions. Their are also facing competition from the Money Market funds which hit new AUM record of $5.6t. As mentioned in last week’s update, this leads to historic declines in deposits, and adds pressure on the bank’s profitability.
Junk debt issuance picked up in August, with Leveraged Loans volume now just under August 2019 levels, and High Yield August volume being highest in many years. Issuers are taking advantage of tight speeds, which are not compensating investors for any macro uncertainties. Currently spreads are 120 bps on IG and 370 bps on HY, which is very rich for the current economic backdrop, inverted yield-curve and tightening bank’s lending standards. Those tight HY spreads, similarly to the high equity multiples, are driven by the same investors expectations of a soft landing. However HY investors, may not get enough compensation for the risk they are taking if economy would deteriorate. With increased number of maturities in 2024 and 2025 and uncertain outlook on earnings growth, there will be an increased pressure on the interest coverage ratios. In addition, due to a spare liquidity from pandemic era, there could be a significant delays, before the rapid increase in financing costs will impair the financial strength of corporations.
EQUITIES
Companies have been managing this environment exceptionally well. Q2 earnings excluding energy sector where up 3% YoY, ending the earnings recession. The consensus however remains bearish, with the expectations that the growth and earnings going forward will be challenged. Equity valuations for most of the year where rich, and with latest part of the rally, equity risk premiums fell below the IG credit spreads (measured by comparing the LTM earnings yield with IG OAS).
From the sector perspective, weakness in banking remains most noticeable. All banks are trailing S&P for this year, biggest losers are regional banks (which on aggregate are trailing big banks 20-25% YTD), but even money center banks are heavily trailing indexes with prices of Citygroup now 30% below the S&P performance for last 12m (-25% YTD). Overall banking sector have been underperforming since the GFC, but even with current heavy discount there are a lot of value traps in the sector. Furthermore the regional banks are under pressure from regulators, who are now putting more pressure on lending standards and more emphasize on fee based income, as oppose to revenues from the lending pipeline.
We are also getting closer to Q4, where focus will shift to retailers, most of whom drive close to 70% of their average yearly income from the 4th quarter. This year’s 4th quarter is expected to be particularly tough since there are two major headwinds ahead:
- Student loan repayments will resume
- Consumer post-pandemic excess savings are rapidly decreasing
- Spending growth outpaced income, taking saving rates down to 3.5% (lowest level since November 2022)
Overall retailers has been using a lot of line items to explain their underperformance, including ‘shrink’ and inflation. Those two points will give CEOs more ammunition to explain the underperformance from the macro perspective. But there are a lot of micro factor that have been neglected over the years. Many retailers haven’t adopted to the changing of ways people shop – how, where, and when have changed drastically since pandemic. It is much more integrated world, where online and off-line need to be integrated through technology with more emphasis on production and distribution of content. Investor in retail sector should take this into account as it can create significant advantages for some players and help them to increase market share and to drive the bottom line.