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The Weekend Edition # 33
Quick market recap; Macro Thoughts - This time it may just be different!; Retailer Earnings
Welcome to another issue of the Weekend Edition.
Thank you to all who’ve read and subscribed to the newsletter this week!
Here’s what we cover:
Market Recap - Quick recap
Macro of the Week - This time it may just be different!
Earnings of Week - Retailer Summary
The Week Ahead - Economic and Earnings Calendar
Let’s dive in ⬇️
Market Recap - Feb 28 - Mar 04, 2022
Markets remain in correction territory and an extremely volatile situation - event driven by the geopolitical situation, exacerbated by the decline in liquidity in the markets. Commodity prices are still soaring - oil, gold and soft commodities lead the way. And any earnings miss or weak guidance is met with a magnified downward response.
WTI Oil kept gaining strength throughout the week and hit a 52-week high, as soon as news broke that the US is considering sanctions on Russian oil. And then there’s wheat - that hit a 14-year high because Ukraine and Russia are among the largest wheat exporters in the world. These increases in commodity prices have the makings of sending a shock through the world economy. We’re getting hit at the most basic levels - bread basket and oil. These prices are not sustainable.
Macro of the Week - This time it may just be different!
Fed Chair Powell confirmed this week that he’s going to be proposing a 25bps (0.25%) rate hike during the next Fed meeting which is on 15-16 March. So in 10 days we will know if Powell’s proposal gets the green light. Well, we all know that he will get the votes and consequently there will be a rate hike.
But, I wanted to take a look at what’s different this time from the previous rate hiking cycles.
The Yield Curve
I had written a primer about the yield curve back in October, along with the scary notion of the curve inverting. A quick way to look at the yield curve, is to look at the diference between the 10Y US treasury rate and the 2Y US treasury rate, i.e., the difference between long-term and short term rates. So as the difference narrows, the yield curve is becoming flatter.
If you look at the picture above, this 10Y-2Y curve is lower than when it was at the beginning of the previous rate hike cycles. I realize this is only goes back 20 years but it’s still an important consideration. So what happens next? Here’s a crude drawing of the way I see it:
Nothing spells trouble like tightening into a growth slowdown. According to the Atlanta Fed’s Nowcast Model - “The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2022 is 0.0% on March 1, down from 0.6% on February 25.” So, you have a situation where growth is slowing as it is and then you’re removing liquidity from the economy, which leads to a magnified negative effect.
Inflation will not respond to rate hikes immediately. There’s always a time lag. And there will need to be several hikes and quantitative tightening, before there is a dent in the level of inflation. Moreover, much of the inflation stems from supply chain issues that have not normalized. If anything, things have gotten worse because of the geopolitical situation. Oil, Gas, Fertilizer, Soft Commodity prices are raging and all of this will continue to put upward pressure on prices.
Companies and Valuation
The US stock market has had historically high valuations in 2021. We’re already seeing much of these valuations come down but, there’s still more to go. We’re seeing earnings estimates and guidance rolling over, i.e., coming down from peaks.
As interest rates increase, so will debt costs. And we will see further downward revisions. Coupled with labor shortages and rising input costs, companies are in for quite the ride.
If you look at the chart below, Forward Earnings has been coming down for a while now but, the latest estimates now show that forward revenues are also coming down.
What’s the easiest way for a company to cut costs? Firing people. It’s sad but true. The company has a fair bit of control over labor costs and it’s a quicker option in many cases. If revenue estimates are declining, debt & commodity costs are rising, and there’s only so much that people can raise prices, we will see labor cuts. The only respite to this is that the unemployment number is still at a very low level (3.8% this Friday from 4.0%). This was not the case during previous rate hike cycles. The number was higher both in 2004 and 2015. At the time, the unemployment rate came down with the rate hiking cycle but, then inflation was not raging.
The Balance Sheet
Last but not least, we have the Fed’s $9T balance sheet. $9Trillion… let that number sink in for a bit! The Fed Chair has already alluded to using measures for reducing the size of the balance sheet - which can only mean the assets sales or quantitative tightening. So there was some measure of QT during the last hiking cycle but, well after multiple rate hikes, and the result was still not pretty. The S&P 500 fell -19.8%!
This time however, the Fed may do both and soon. Talks are of QT starting soon after hikes - possibly 2H, 2022.
Consecutive rate hikes + Quantitative Tightening (QT) will lead to a possible recession. And the truth is, the Fed just may tighten into a recession with the idea that they have the tools to “fix” it, if that happens. This is not the first time this has happened and it probably won’t be the last.
We need to brace for impact because the stock market does not handle recessions very well.
Earnings of the Week
Since I wrote a longer than usual macro section, I’ll keep earnings reviews brief. We had a few more retailers report earnings this week along with a few much anticipated tech names.
Retail is definitely experiencing margin compression because of rising costs and comps becoming challenging.
Costco saw gross margins drop 0.32% but up 0.05% excluding gas inflation. Core merchandise margins were down 0.43% excluding gas.
Dollar Tree posted decent earnings but guided down to single digits for Q1, 2022. This was despite the fact that the increase in price to $1.25 has now been rolled.
Kroger delivered fantastic earnings with an EPS beat of 23%, it’s fifth double digit beat in a row. They also guided up on their EPS by about 3% YoY. The company’s done well to retain employees, paying them more and ensuring they have better benefits. The company will probably will definitely be facing tougher comps as well but, they seem better placed to deal with it. This will be one to watch.
No surprise that Zoom beat both top and bottom line estimates but traded down on earnings because of slowing growth numbers. This is what it’s been like for a last 3 quarters and once again the comps rule the day.
The Week Ahead
Tue Mar 08 - Wholesale inventories
Wed Mar 09 - JOLTs - Job Opening Data
Thu Mar 10 - CPI and Core CPI Data (inflation data)
Fri Mar 11 - Sentiment Data
I realize that much of what I’ve written in this newsletter makes certain assumptions and there are other factors to consider. There will always be other factors to consider but, as always I wanted to give you a few things to think about.
Personally, I think the US Federal Reserve is the world’s most powerful institution and what they do and what they don’t do moves markets across the world. So it’s worth thinking about what could make them change course.
Here’s wishing you a happy weekend and safe investing.
Ayesha Tariq, CFA
There’s always a story behind the numbers
None of the above is Investment Advice. I may or may not have positions in any of the stocks mentioned. I have a long position in $WEAT as of the date of publication of this newsletter. I have no affiliation with any of the companies that are mentioned.