In the stock markets, the week has got off to a mixed start as investors digest company results and the mixed economic data.
In this post, let's talk briefly about the earnings season that is better than feared. Then we take a look at the world's most anticipated recession, which keeps us on our toes. In fact, the recovery of the construction sector in the US may at some point start to accelerate economic growth. Thirdly, we’ll talk of the impact of oil prices on cooling inflation. Finally, let’s discuss a slightly broader topic of how rising geopolitical risks have been shown to fuel inflation, weaken economic activity and reduce the volume of world trade.
As you can see from the number of topics, this is a slightly longer read. With the rest of the week being very busy with the start of the earnings season now well underway in Finland, this will be the only What’s Up with Stonks this week.
A better-than-feared earnings season continues
Let's talk a bit about the earnings season in the US.
The season has gone better than feared. Just under a fifth of S&P 500 companies have reported their results and 76% of them have exceeded expectations. The average earnings beat has been just over 5% and the share price reaction to the results has been marginally positive. In other words, investors seem to be enjoying the results. So far, positive surprises have come from banks, builders and of consumer brands, Coca-Cola. At the same time, investor favorite Tesla served up disappointing results and slipping margins.
This is shaping up to be a busy earnings week, with McDonalds, Spotify, Microsoft, Alphabet and Amazon among the companies reporting their results.
With better-than-expected results, the S&P 500 is now expected to fall by 7.3% in the first quarter, a forecast that has been on the rise for some weeks. However, earnings forecasts for the second and third quarters continue to show a downward trend. Investors look ahead and what matters most in earnings reports is how they affect investors' perception of future cash flows. So far, the results haven’t encouraged analysts to raise their forecasts.
Still waiting for that anticipated recession
Last Friday saw the release of fresh purchasing managers' index data for the eurozone and the US. Purchasing managers' indices are one of the best and most real-time measures to monitor the economy, as they are published monthly. They paint a twofold picture.
Let's look to Europe first. The figure for services accelerated to almost 57 in April. A reading above 50 indicates an increase in activity compared to the previous month. The service sectors are effectively the lion's share of the economy, so they are the ones that swing the baton more. Strong performance is good news for the economy and thus the eurozone should continue on a positive path. However, price pressures will also continue. This bodes ill for inflation developments and puts pressure on the ECB to raise interest rates and keep rates high.
By contrast, the outright industrial recession deepens as the index dips to 45.5. However, price pressures are easing on the industrial side. Companies in both manufacturing and services are optimistic about the future. Supply chain disruptions are behind us, a relapse into the energy crisis seems unlikely and inflation is expected to gradually decline.
It should be mentioned briefly that a survey by the German Ifo Institute showed a further improvement in the future expectations of German companies. This is not really consistent with the expectation of a recession.
Across the pond, the services sector in the US also developed rapidly. Interestingly, the manufacturing index also bounced above 50, back into growth territory. This contrasts sharply with a similar survey by another pollster, ISM, which reports a steeper deterioration in the state of industry. This difference may be explained by the fact that the ISM sample is over-represented by large companies with large exports to the rest of the world, whereas this S&P Global sample includes smaller companies. The domestic market is doing well, according to companies.
Unfortunately, price pressures rose again in April, reflecting the persistence of inflation. Be that as it may, there is no sign of a recession, and according to S&P Global, such purchasing managers' index figures predict a healthy growth rate of 2% for the US economy.
In addition to these factors, the housing market is showing signs of leveling off. Housing investment has been a major drag on GDP growth in recent quarters and is expected to remain so for some time. In practice, US GDP growth would have been more than a percentage point stronger in recent quarters had the housing sector not been weighing it down.
The rapid rise in interest rates has made mortgages significantly more expensive and stalled the housing market. Many homeowners don’t want to sell their home because they would have to take out a higher-interest mortgage to buy a new one. But demand for housing seems to be recovering despite high interest rates, people have to live somewhere and, in the US, just under 50 million people are between the ages of 25-34, i.e., the age that first homes are usually bought. Housebuilders are producing fewer homes than they sell, so at some point supply will be even more scarce and this will support house prices.
No wonder then that housebuilders' shares have rebounded strongly from last fall's lows. Significantly more homes should be built and there is a healthy demand for them. But if residential construction starts to pick up, this should significantly help the economic figures in the future.
Here's another funny graph from Lombard strategist Dario Perkins, showing the ratio of US homes to GDP and mortgages to GDP. Prices have gone up, but debt has not. If house prices do fall sharply, it won't be the same problem because owners will have less debt to worry about. The real concern is commercial real estate, especially office space, but I'm not sure if the fall in that sector is as significant for the overall economy. However, the collapse of that sector is a big reason for the decline of the banking sector, as small banks in particular are major financiers of office space in the US.
How does the rise in oil prices affect inflation?
As my active readers know, inflation is wobbling quietly downwards despite its persistence. This graph shows the current forecasts for inflation by Bloomberg economists. In advanced economies, inflation should move to 3% by the end of this year and next year the central banks are aiming for 2%. Globally, inflation is wilder, but easing in any case.
Macro-forecasts are imprecise, but it's good to be aware of them in the sense that this is roughly the kind of development that the market could at least be expected to price into equities now. If inflation comes in below expectations without a worse recession, equities would be golden. If the inflation data is more persistent — well, damn it.
A few weeks ago, the oil cartel OPEC+ cut oil production, which at least temporarily boosted oil prices. I didn't mention it immediately around the time because I had nothing sensible to say on the subject. Moreover, OPEC production cuts do not necessarily mean a longer-term price recovery if they are due to weak demand. However, they seem to have a better idea of the oil supply than many others. After a brief price spike, oil prices have continued to fall due to recessionary concerns.
However, if oil prices were to correct sustainably upwards, this could start to show up in inflation later this year. At the moment, the price is significantly below last year's level, so the oil price is lowering inflation at the moment. If the price were to rise to $113 a barrel, inflation in the US could rise back up to 6% at the end of the year, instead of the forecast 4%.
Monetary policy and investors in a multipolar world
Christine Lagarde, President of the European Central Bank, gave an interesting speech last week in New York on how central banks can respond to the fragmenting geopolitical situation. Given the huge importance of monetary policy for equities, I will quote a few observations from this speech.
As everyone will have noticed, the post-Cold War hegemony of the United States is being challenged, especially by China and Russia. Instead of a unipolar, rule-based world order, these challengers advocate a multipolar, camped-out world where the power of the strongest dominates.
These challenging groups are trying to attract more countries to their camp. Russia is running low on friends and North Korea and Iran shouldn't retaliate too much, but China has pull in many Central Asian and African countries.
This fragmentation of the global economy into self-interested groups is reflected in supply chain challenges and fuels inflation.
In a globalized world, production was outsourced to cheap countries, and this had a major chilling effect on inflation. Inventories were kept to a minimum because more stuff could be ordered at a moment's notice. In other words, production was, to put it nicely, elastic —responsive to rapidly changing demand.
This is now in the past. Dependencies are a weakness because they can be exploited, as Russia tried to blackmail Europe with its energy weapon. For example, 98% of Europe's rare metals come from China. In response to this threat, the West has several economic policy programs aimed at increasing self-sufficiency. For example, the US has the Inflation Reduction Act.
Businesses are also reacting. According to Lagarde, the number of companies considering decentralizing their supply chains in Ukraine rose to 45% of global firms after the start of the war, double the previous year's figure.
Rising geopolitical risks have been shown to fuel inflation, weaken economic activity and reduce the volume of world trade. If supply chains break down and adapt to new geopolitical camps, one study suggests that consumer prices could rise by 5% in the short term and 1% in the long term. Sudden geopolitical tensions can bring supply chains to a standstill, at least for a while, and fuel bouncing inflation.
At the same time, many countries are trying to reduce their dependence on the hegemony of the dollar in trade, although despite years of defiant rhetoric, no serious challengers have emerged for neither the dollar nor the world's second currency, the euro. It’s difficult to trust the currencies and capital markets of authoritarian countries.
The fragmentation of the world order also affects economic policy. In a competitive world, the movements of one bloc affect all the others. This will force politicians and central banks to take a closer look at what is happening in the rival camp's economic and monetary policies. For example, instead of governments and central banks trying to support inflationary consumption as they did during the pandemic recovery, the West should continue to support domestic production and resilient supply chains. More domestic production means less inflation. This supports economic growth in a difficult situation. For Europe, this means further deepening cooperation so that the EU and its individual small member states can compete globally. Doing better also increases the attractiveness of your group relative to your competitors in a multipolar world.
There were many important themes in Lagarde's speech that more or less directly affect investors. The developments of recent decades, where world trade and cooperation deepened, seem to have come to a standstill or even gone backwards. The role of the right economic policies will take center stage. When looking to add new stocks to your portfolio or sell existing holdings in your portfolio, you should consider their supply chain and geographical risks. Inflation may be receding now, but it’s more likely to return to a fragmented world than in the past. Like in the 70s. For stock markets, times of geopolitical fragmentation, such as world wars and the period between them, were no great feast. Let's hope there is no reason to go back to those days.
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