Are recent gains a signal that US equities have hit bottom and are poised for a sustainable turnaround or merely a dead cat bounce on the way to more losses? That is the trillion-dollar question on every investor’s mind. We are inclined to believe it is the latter primarily because we think current earnings expectations — estimated to grow 9% to 10% in 2022/23 on the back of near-record-high margins — remain overly optimistic, given the prevailing environment of rising costs of doing business. If so, that means stock valuations are in fact higher than indicated, based on current estimates.
Notably, we are not alone in this thinking. The chorus of similar narratives has been growing louder in recent days. Yet, analysts have, surprisingly, not revised down their forecasts. To be sure, the majority of analysts and asset managers tend to be an optimistic lot and, yes, they do have vested interests in talking up markets. But perhaps they are also hoping that the worse will not come to pass. Indeed, US economic data remains relatively resilient so far, all things considered. The ongoing earnings reporting season for 2Q2022 and, more importantly, management outlook and guidance will provide valuable insights as to whether the sanguine forecasts are justified.
The financial sector has been among the first to report their results (it is still early days into the reporting season). Most have come in below market expectations. Earnings were dragged down by sharply lower revenue from investment banking (corporate exercises, new listings and deal-making) and mortgage origination. Banks were also making larger loan loss provisions, in anticipation of defaults — signalling caution on the outlook. JPMorgan Chase & Co and Citigroup have temporarily suspended share buyback to shore up capital while Goldman Sachs Group said it was “actively reviewing” its programme. That said, one common thread has been that consumer spending and credit growth remain strong, even with the highest inflation rates since the early 1980s.
Banks, with their wide customer base, are well positioned to assess the financial health of households and businesses. Every recession is different. And this coming US recession (if there is to be one) will be notable in that households and corporates are largely in good financial shape. The job market is exceptionally tight and, with unemployment near the lowest in five decades, employees have more bargaining power than they have had in many years. JPMorgan, the biggest bank in the US, noted that median checking account balances across all income quartiles for its depositor base are higher today than they were pre-pandemic.
While various recent surveys indicated that confidence had plunged, consumers are still spending. Case in point: The latest retail spending report showed a 1% year-on-year growth in June, bouncing back from the weakness in May. Overall spending, even after adjusting for price inflation, remained remarkably resilient, though purchase of big-ticket items such as homes and autos are starting to decline. The average savings rate has dropped but households are still sitting on trillions of excess savings from the pandemic — thanks to government largesse — which some estimate will take many months to run down. This will complicate the US Federal Reserve’s fight to tame inflation.
Furthermore, today’s rising prices are also being driven by supply-side factors beyond the Fed’s control, including lingering effects of the pandemic and geopolitics. We have written about how concerns for supply chain resilience, national security and self-sufficiency will lead to more reshoring and friend-shoring — where a more polarised world will, inevitably, result in lower productivity and higher costs. They all point to the next 20 years of reversal from the gains of globalisation — prices will eventually stabilise at higher than originally anticipated levels. There is a rising probability of self-inflicted stagflation in Western countries, feeding into the developing world.
Although much of the narratives have focused on the probability of recession in the US, the worst impact of rising prices will be felt in the rest of the world, including Europe and especially in developing nations. The Fed, we think, will err on the side of caution to preserve its credibility. Thus, it will front-load an aggressive interest rate hike schedule — far more so than the rest of the world, partly because US households and the economy are on a stronger footing.
A widening interest rate differential as well as increased risk aversion amid heightened economic and geopolitical uncertainties are pushing up the US dollar. The greenback is now trading around parity with the euro, for the first time in two decades, and has strengthened even more against the Japanese yen (up more than 25% from a year ago). A strong greenback helps the Fed’s task in tempering inflation, by reducing the costs of imported goods and services. On the flip side, it will compound the pain for the rest of the world, by exporting inflation and raising the servicing costs of US dollar denominated debts. Economist Nouriel Roubini believes the world is looking at a severe stagflationary debt crisis — with public and private debts now at 350% of global GDP, up from 200% in 1999. We may not necessarily go that far, but the revolution in Sri Lanka may not be the last we see in this crisis. There is a price to be paid for the excesses built up through years of ultra-easy monetary policies, which have distorted the allocation of resources. Part of the blame, however, must lie with growing US hegemonic power in the world, since the end of WW2. We will explore this issue further in a future article.
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The International Monetary Fund warned that it would “downgrade our forecast (for global GDP growth) substantially” in a review due this month, having already made a downward revision in April. Many large US corporates derive a substantial portion of their revenue and earnings outside of the US — overseas sales account for roughly 40% of total revenue for Standard & Poor’s 500 companies, according to data provider FactSet. These companies will be affected by weaker global demand, even if the US avoids a recession. The strong greenback will also hurt the value of earnings derived overseas in US dollar terms. In short, the likelihood of earnings shortfall from current expectations is high. Share prices for the broader market are driven by earnings and/or valuation multiples (which is a function of interest rates). And the upside on both fronts appears limited — for now.
The Global Portfolio gained 1.9% for the week ended July 20, led by Airbnb (+12.6%), Chinasoft International (+6.3%) and Bank Rakyat Indonesia (+6.2%). Elsewhere, the two losing stocks were Alibaba Group Holding (-3.9%) and Yihai International Holding (-2%) while the iShares 20+ Year Treasury Bond ETF also ended 1.6% lower. Last week’s gains boosted total portfolio returns since inception to 28.1%. The benchmark MSCI World Net Return Index is up 35.9% over the same period.
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