The Weekly Random Walk – May 23, 2023 – from Stephen Colavito
An Aggregation of Various Economic, Market Research, and Data
Reviewing data over the last few weeks, it has been interesting to see the bifurcation of economic data versus market performance. Despite an economy slowing and lawmakers (still) working on budgetary and debt issues, the Nasdaq continues to climb while the S&P hovers just broke above the top of its range. This week we are going to examine some of this data.
Credit Or Labor, What Are You Worried About?
Goldman Sachs reviewed earnings transcripts from Russell 3000 companies. One notable finding was the share of management teams citing labor shortages declining (about 3%) from the late 2021 peak of 15%. Despite sticky wage inflation, there was a higher share of companies discussing tightening bank lending conditions and the difficulty of accessing capital. This research is consistent with other credit surveys we have read and will likely affect the economy over the coming quarters.
Proxy Rates
Deutsche Bank ran models using a variety of influences on different proxies for the fed funds rate. Using conventional financial conditions indicators (FCI), rates, spreads, equities, and volatility, all show a similar reading to the actual fed funds rate. However, when you include those same measures and incorporate tighter credit conditions via the reduced credit supply (as measured by the Fed Senior Loan Survey), proxy rates are roughly 6.5%, almost 150 bps higher than the actual Fed funds.
Consumers Have Put the “L” in Leverage
In a bit of an ominous sign, total consumer debt hit a fresh new high in the first quarter of 2023 at just over 17 trillion dollars. The chart below from Charlie Bilello shows that credit card balances increased 17% year over year (Q1), according to the New York Fed’s most recent report. This is the largest jump in revolving debt in twenty years. At the same time, interest rates on credit card debt have skyrocketed, with the average rate climbing from 14.6% to 20.1% today. Even though there has been little impact on retail sales (year-to-date), it would appear that the future of discretionary spending in the consumer space may be limited unless we see significant wage gains (which ushers in more inflation problems).
More evidence is the recent report on delinquency rates (the share of current debt becoming past 90 days) that have increased for the fifth consecutive quarter for most types of credit.
However, unlike the government, consumers still have another 3.5 trillion in available credit if a new sale on X-boxes or 110-inch TVs becomes available. Yikes.
Mortgages Up, Home Sales Down
The average American buying a home will now pay over 7% on a 30-year fixed mortgage (as of writing, the rate was 7.04%). This is the highest rate in two months. This is not a “death blow” to housing, but it certainly hurts home sales. Although New Home Sales surged in April, when looking through the report, it came from builders slashing prices to move inventory.
The chart below shows home sales are down 14 out of the last 15 months. In a report from the Realtor Association, existing home sales are down to levels seen in the mid-1990s. The good news is that prices have not crashed (so consumer net worth is still intact), but transactions have declined.
Mixed Signals in Commercial Real Estate
Commercial real estate loan quality has continued to improve, with average loan-to-values (LTVs) now at 52% for first-lien loans and debt service coverage ratios (DSCR) still at 2xs, implying that lenders should be able to service their debt. However, the office sector is still struggling with vacancies (which are rising) at 19%. Rents increases are only rising by 2.2% year-over-year, thus not keeping pace. Many office properties with variable financing or loans coming due are struggling as rates remain elevated. For example, rents in San Francisco (where crime has increased by over 10%) continue to fall. The saving grace is that strong underwriting keeps problems with first-lien loans somewhat muted…for now.
How Slow Can You Go?
The money supply (M2) is shrinking for the first time since 1960. Yet despite the precipitous slowdown, inflation remains sticky, contrary to what we have learned in Econ 101.
In Mid-April, the BLS reported that monthly CPI was +0.66, equating to nearly 8% annualized rate and well above the 2% target set by the Fed. Two weeks after the April CPI report, the Fed stated in its minutes:
With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2% for some time inflation averages 2% over time and longer-term inflation expectations remain well anchored at 2%.
I believe the Fed would be happy with inflation at the 3 to 3.5% level. But inflation concerns by the Fed mean that although they may not want to raise rates further (because of pressure on banks), they are likely to stay at this level for quite some time. Fed Fund futures are pricing in cuts for 2023 (which have elevated equities). That is overly optimistic, particularly after the Core PCE Deflator disappointed the doves this week with a hotter-than-expected number.
If the Fed cuts rates, something has broken (labor markets, economy, etc.), and they must come to the rescue.
What Went Down Has Come Up
Switching to public markets after a horrendous 2022, the 60-40 portfolio of equities and treasuries is up about 26% this year. Bank of America adjusted their price target on the S&P 500 to rise to 4400 (currently 4205.45) while they estimate the 10-year treasuries move to 4%. Over the last few weeks, Fed speakers have been hawkish, reiterating the policy stance in their minutes, indicating future hikes are not off the table. Fed Fund Futures believe rates will be approximately 4.60-4.65 percent by year-end. This has been a catalyst for equities despite higher than mean forward EPS.
Although the S&P has struggled to move above 4200 (which it did Friday), most believe that when the debt ceiling deal is settled, the market will push above the resistance. My recommendation is to continue to fade a rally above 4200 into 4300.
It’s All About the Mega Caps
Despite weakness this week in markets, the mega rally in mega caps has not gone unnoticed by investors. After all, large-cap tech stocks are deemed to be the largest beneficiaries of the boom in artificial intelligence (note: a human, not ChatGPT, writes this update). The S&P 500 equal weight index has trailed the S&P 500 by 7.7 year-to-date. Similarly, the NASDAQ 100 equal weight index has lagged the NASDAQ 100 by more than 10% over the same period.
Buying into these mega names has intensified over the last few weeks.In speaking to a trader at Goldman Sachs, he noted that notional net buying from 5/5 – 5/18 (in US equities) was the largest since October 2022. After Nvidia hit a 450-foot homerun over the center field fence, I wouldn’t be surprised to see more dollars sitting on the sidelines chasing for the next few weeks. It’s what markets do.
No Bubble In SMID
The tech bubble in smaller-cap tech stocks has completely evaporated, with the ARK Innovation ETF back at levels not seen since 2018-2019. As the chart from BoA shows, the divergence from AAPL vs. ARKK has been extraordinary.
Neo – Dodge the Bullet Points
The path of least resistance for equities is that a debt ceiling deal is done before the “X-Date.” That allows the market to create a new range (to 4300) if liquidity buys on the news. If lawmakers cannot reach a deal, prop desks and some of my hedge fund PMs I spoke with this week think that a 10-15% drop is not out of the question. I was surprised that most people I spoke with sang from the same hymnal.
When (notice I didn’t say “if”) Washington gets its (well, you know) together (before or after default), the US Treasury could issue anywhere from 700 to 1 billion dollars of T-Bills. They will need to refund the TGA, which is drained. I expect that T-bill prices will likely decrease, and yields will likely increase. This is the law of supply and demand.
This brings another issue to bear…liquidity. The liquidity suck going into T-bills means it’s not there for equities. Plus, higher rates mean the equity risk premium gets worse. TINA is again replaced because you can get paid more to go elsewhere. The narrow market would have to expand quickly, or it will likely get exposed. Hence one of the reasons I fade into a rally in equities (I am sticking to my guns…so to speak).
To add one more log on the equity fire. If you want to see a mind-blowing stat, look below at large-cap technology names:
— META +108% YTD with a 22.6X PE – Nov 2022 it was at 8X PE
— NVDA +145% YTD with a 162X PE (Forward is around 50X) – Oct 2022 it was at 31X PE
— AMZN +40% YTD with a 125X PE – June 2022 it was at 60X PE
— AAPL +33% YTD with a 29.2X PE – Dec 2022 it was at 20X PE
As discussed in the early part of this report, core inflation is sticky, and food inflation is still in the high teens for YOY cost.
In the “Investing intersects with the corporate governance front,” Gallup did an interesting ESG survey. The political divide is straightforward, Democrats love ESG, and Republicans are rebelling. But what is interesting is that only 37% of the population report being “very” or “somewhat familiar” with what ESG is or what it means. This poll was conducted in April, and what is interesting in this study is that 59% have “no opinion” when asked if they view “the moment to promote the use of environmental, social and governance, or ESG factors in business and investing “as a positive or negative development.” Of the 40% that remained, it was evenly divided between expressing a positive (22%) and negative (19%) view of the practice.
Lastly, with little fanfare in the US media, a week ago, the Arab League welcomed the Syrian regime back to the organization. Syria has been suspended from the league since 2011. Even though the US policy is staunchly opposed to Assad, the League’s rapprochement with Assad is seen by many as a repudiation of US policy. It is also a sign that the US influence among League members (who are now open about their disdain for the current administration) has waned. This comes just weeks after Iran and Saudi Arabia reestablished diplomatic relations, and another sign is that Washington’s influence in the region is declining.
— Note: The importance of this cannot be understated. The current administration’s anti-fossil fuel policy, criticism of the Saudi Kingdom, and continued sanctions on Russia and other countries could have considerable trade implications in the future (particularly on the energy front). This needs to be observed, and it is getting zero attention from domestic media.
Please remember that Memorial Day is not just for BBQ and the beginning of summer but a day to honor and mourn those in the US military who have died serving this country. While enjoying the long weekend, I hope you take a moment and thank those who gave the ultimate so we can do the things we love.
Thanks for listening.
Stephen Colavito, CIO
San Blas Securities
stephen.colavito@sanblas-advisory.com
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