So far, about 22% of the market cap for the S&P 500 have reported results. Quarterly updates pick up in earnest next week, with the following large and very important companies: Visa#, Alphabet (Google)#, Meta Platforms (Facebook)#, Merck#, McDonald’s#, Apple# and a few oil firms to name a few. Suffice it to say, next week will be critical for the direction of our next 5% move higher or lower. Reported sales growth thus far has been ~7%, slightly lagging inflation. In simple terms, volumes are flat but pricing gains being passed to consumers are still higher than usual, creating decent revenue growth. Since input costs are also rising, margins are contracting. That top line expansion is actually leading to an earnings decline so far. Companies are beating lowered estimates in line with normal ranges.
Stock by stock action is wild, as expected. For every Netflix#, which popped 13% following much better-than-expected subscriber gains, there is a Tesla which set a new annual low and fell ~7% on less than hoped for sales. As AT&T takes more market share in the wireless industry, they jumped 8% following their 3rd quarter earnings release. On the other end, you are not in good hands with Allstate. That stock dropped 13% stemming from Hurricane Ian induced losses. In bear markets, even quality companies can have a bad quarter or two and see their stock prices collapse. Getting in front of these earnings updates is not recommended. Anything can and will happen, positive or negative.
A few things have been consistent in our readings of these calls. Covid induced sales are reverting to normal. Stocks that benefitted are still seeing pressure today. Pricing power is good for some, but not all. Higher interest rates are impacting cash flows. Companies loaded up on debt at much lower levels in years past. Now, when those bonds come due, they are either paid off (good longer term) or refinanced at substantially higher rates (bad). Both actions lead to more cash going into a debt pile instead of share buybacks, corporate expansion or dividends. That is not constructive for stock gains in those heavily indebted companies.
One thing is certain; we are only 7 months into this Fed rate hike cycle but economic conditions are vastly different from March. The Fed was very late to the game. Now they are forced to pound the table on “front-loading” rates higher in order to get inflation back down to acceptable levels. Only 1980 compares to a Fed going this far, this fast, which produced an obvious recession. Many are expecting another 150bps in rate hikes before year-end. Yield curve inversions are only going to get worse. Operationally, companies and industries have not had much time to change. When interest rates go from 0% to 4.5% in under a year, something usually breaks. The more rate hikes pulled into 2022, the more likely a soft landing is not happening and vice versa.
Select Inflation Categories/Upcoming Crash?
I want to touch on two specific areas that helped drive goods inflation over the past few years, namely autos and housing. Each have hit an inflection point. Each are starting to see improved supply chains. Each are facing a more uncertain consumer. Lastly, each are running into a much different supply/demand scenario as interest rates wreak havoc on consumer affordability heading into 2023.
The entire auto spectrum, including new vehicles, used cars and trucks, and motor vehicle maintenance, represents a 9% weighting in CPI calculations. That is a decent needle mover. Looking back, this was one of the first sectors affected by supply chain snarls as Covid induced lockdowns dragged production of new cars down from 97 million globally to 78 million in 2020. Manufacturing has barely budged from those low levels since then. This was a key reason why used car prices rose by 50%, car parts became scarce and new vehicle prices skyrocketed. Everyone had to keep repairing their old cars or were forced to buy what was left in the market at whatever price was offered. For many, automobiles are a necessity, not a choice. Simple supply and demand dynamics were at the forefront of this inflation cycle.
With production finally improving as semiconductor chips come to market, factories are going to be near full capacity in 2023. Finally, we are seeing a real inflection point for the used car market. Prices just put in their largest yearly decline on record, dropping by 10%. It will take more time to get back to normal pricing (check out your local used car dealership prices), but since it was a leading indicator for our current inflation mess, this data point is encouraging for lower inflation down the road. More supplies are coming. That is good news for the consumer. However, pair that with ultra-high interest rates and buyers may become scarce. Auto retailers will be forced to lower sticker prices. They missed out on sales for the past three years, and now that supply is coming, they face a double whammy of tighter budgets and rising financing costs. Nobody said the auto industry was easy! The entire auto complex could be a negative contributor to overall inflation statistics shortly.
Another sector we have frequently referred to during these inflationary times is that magical black box computation for shelter, which includes rent of primary residence and owner’s equivalent rent of residences (what one would pay in order to substitute a currently owned home as a rental property). Combined, the housing industry represents 33% of overall CPI. Housing is also 20% of the U.S. economy. Americans have a larger ownership of homes than they do from investments in the stock market. This is critical to overall net worth and a massive driver of inflation.
With homes there are 2 significant variables to make a purchase, the offering price and financing costs. Monthly payments based on the average home price have certainly surged due to both variables. In fact, those costs are basically double from pre-pandemic and nearly quadrupled from the Great Recession!
Source: @TheTerminal, Bloomberg Finance L.P.
Unsurprisingly, cracks are starting to appear. Homebuyer traffic has collapsed back to the 2009 housing crash level, declining 61% last month. This is coming as builders, who have been preparing for this moment by not spending all their earnings on new land, have a near record number of homes under construction.
Again, simple supply/demand dynamics. Supply is above historic norms with respect to new homes (used home listings are still quite low). Costs are extremely elevated. Existing home owners are locked in at 3% – 4% mortgages. Selling/moving into a new location means they must take on a 7+% loan unless they qualify for porting their mortgage. New buyers are now depleting savings accounts and are not able (or wanting) to spend such a large portion of their incomes on a new home. Prices must keep coming down, along with rents, if these units are to be sold or occupied. Again, another major CPI goods component that could be a negative input variable in 2023, but with a serious lag. Owner equivalent rent computations are ~6 months behind the real market.
Granted, these are only 2 subsets of the inflation picture today. Services inflation is holding steady. Gas prices have come down from a peak but are quite elevated relative to pre-pandemic. The average consumer still has a savings/checking account 2x – 3x normal levels due to previous Government handouts, higher wages and a fully employed workforce. They can spend more in a recession than is typical. Although it is easy to see inflation coming down over time, it is not easy to see a 2% target hit anytime soon.
This keeps the Fed aggressive in their actions as they continue to focus on backward looking data. Looking ahead, we could have recessionary conditions across numerous industries (housing & auto) while others hold up (energy & software). Rising interest payments for consumers and corporations alike eventually precede something blowing up. The UK bond market nearly seizing and the Japanese Central Bank losing their battle to cap long-term rates are warning shots.
A bullish scenario exists if the next few updates on CPI and jobs can show some slowing of inflationary and wage gain pressures. Anything that gets the Fed near a pivot could be met with massive short covering and excess cash coming into stocks from the sidelines. The ingredients exist for a natural relief rally, but time is running out on the Fed making yet another massive mistake.
Judge Judy turns 80 today. Actor Ken Watanabe is now 63. Reluctantly, I have to mention Kim Kardashian who is now 42.
James Vogt, 610-260-2214