Barron’s Weekend Summary: Led by a 60% rally in Bitcoin this year, the token market is back to where it was before FTX collapsed in November
Barron’s Weekend Summary
Cover Story:
Crypto is proving resilient. Led by a 60% rally in Bitcoin this year, the token market is back to where it was before FTX collapsed in November, worth an estimated $1.1T. Shares of Coinbase are ahead 70% this year, while Bitcoin “miners” like Marathon Digital Holdings have surged more than 150%. The Global X Blockchain exchange-traded fund, a basket of crypto-related stocks, is up 90%.
Venture-capital funding has tightened, but some large investors are staying the course, helping to keep software developers in business.
Interview:
Barron’s spoke with Apollo Global Management Chief Economist Torsten Sløk on May 10 about the stock market impact of a weakening economy, why a housing recovery might be premature, and the potential risks to the global economy of looming changes in Japan. As for the US economy’s outlook in the wake of regional bank failures, Sløk says that: The consensus estimates a soft landing, expecting we will have a recession in the third and fourth quarters, with a 0.5% decline in gross domestic product in the third quarter and a 0.5% decline in the fourth. That translates into negative 200,000 in nonfarm payrolls for every month from July to December. The banking crisis has created a higher risk of a deeper or longer recession. We are leaning toward a hard landing because of much tighter credit conditions and the fear that rates will stay more elevated because the Fed will be worried about inflation being stickier.
Tech Trader:
This week, Netflix announced that it is installing what it calls “paid sharing” for US subscribers. The new rules say that a Netflix password is intended for use by all of the people living in one household. Anyone not in the household isn’t supposed to use that password and—while Netflix doesn’t say it specifically—the company will soon take steps to block the use of those passwords from other locations. (There are exceptions for devices used while traveling, such as your laptop, tablet, and smartphone.) The company is allowing subscribers to add out-of-the-home family members, but it’s going to cost you
The Trader:
-Artificial intelligence is that unstoppable object, as Nvidia’s first-quarter results and blowout guidance demonstrated this past week. The results sent the stock up 24% Thursday, adding nearly $200B to its market capitalization and extending its year-to-date gain to around 160%.
Nvidia’s very bullish forecast for demand for chips used in AI applications also sent shares of AI-related companies like Adobe and Advanced Micro Devices soaring. The Nasdaq Composite, home to many of these highfliers, finished the week up 2.5%.
-Hedge funds are bullish on their individual stocks, but bearish on the overall market. In the first quarter, they sold banks and technology stocks, while adding to defensive sectors like health care. Those are the highlights from a Goldman Sachs analysis of holdings of 740 hedge funds worth a combined $2.2T at the end of March. Within 45 days of the end of each quarter, hedge funds must report their portfolio holdings to the Securities and Exchange Commission on a regulatory form known as a 13-F. Collectively, hedge fund managers appear to be betting on 2023 being a so-called “stockpickers’ market,” per data from Goldman Sachs.
Features:
For the first decade-plus of Bitcoin’s existence, crypto managed to avoid becoming a political issue, with figures in both parties warming up to what they believed could be a new American industry as important as the internet. This presidential election cycle might kill the heart of that idea, and the implications for token prices will be negative. Before the token crash last year, crypto garnered growing support with both Democrats and Republicans. Bipartisan draft bills sought to clarify how federal agencies should treat tokens–a long sought goal of firms like Coinbase Global that say cryptocurrencies don’t have a clear set of rules to follow. While no major bill made it to President Joe Biden’s desk, it at least looked as if a coalition was building that could provide industry relief on tokens such as “stablecoins.”
-Nearly all states have passed laws designed to limit property-tax increases. But some legislation works better than others. A few states limit property-tax rates, but that can still result in steep tax increases when assessments shoot up. California, meanwhile, constrains increases in property-tax assessments for existing residents, but not for new home buyers. The result is that two families on the same block with identical houses can pay vastly different tax bills. Meanwhile, states like Massachusetts and New York have dramatically slowed property-tax increases for homeowners by limiting how fast the levy for an entire community can rise. But local factors can still affect you.
European Trader:
-Prices of extra virgin olive oil are at a record high, according to statistics tracked by the International Monetary Fund going back to 1990. In April, olive oil was trading for $6,269.63 per metric ton, up 46% from last year’s level. For those who buy their cooking and dipping oils in quantities of less than a ton, that comes out to about $6 a liter (33.8 fluid ounces) at wholesale, or roughly twice that or more, depending on brand and quality, at retail. Filippo Berio, a top U.S. olive oil brand based in New Jersey, calls the latest olive season “the most challenging on record, with the lowest crop yields in 30 years.”
Emerging Markets:
China’s record-breaking youth unemployment rate is grabbing significant attention, and understandably so. The jobless rate for Chinese aged 16 to 24 rose to 20.4% in April, officials announced last week.
That means that 1 in 5 of these 170 million young Chinese attempting to kick-start their careers simply can’t find work. For perspective, the ratio in Europe was 14.3% in March, while the U.S. was at 6.5% in April. Worries abound in China, from the government to universities to families, most of which have only one offspring. That concern may not be translating into helpful solutions, experts said. Government policies are too small or mis-targeted. Universities are adapting too slowly. Even China’s longstanding emphasis on high education may actually be backfiring: a glut of advanced degrees in China has eroded their value.
Commodities:
-Memorial Day weekend kicks off the prime season for backyard barbecues, and Americans are forking over quite a bit less for a few key cookout supplies.
Propane, the gas used to heat many grills and camping stoves, is down 46% from last year, to 64 cents a gallon from $1.19, according to S&P Global Commodity Insights. This month, it hit its lowest level since December 2020.
The biggest reason for the decline: supply and demand. Propane has been building up in storage after a very mild winter because homes just didn’t need to be heated as much. In general this year, prices of fossil fuels from crude oil to natural gas have dropped because of slow economic growth worldwide.
Streetwise:
Wall Street expects Apple’s new device category to be at least a moderate commercial success. Goldman Sachs says that it will goose earnings by a low single-digit percentage starting in 2025. BofA Securities predicts an earnings contribution of 36 cents per share by 2026, or about 5% of the consensus estimate—and much more with “meaningful adoption.”
Perhaps I’ve been too dismissive of virtual reality—for example, by comparing the Oculus Quest 2 from Meta Platforms to a toddler’s toilet seat mounted to the forehead. I bought the hulking Sony PlayStation VR several years ago to see what the fuss was about. It has provided me with nearly an hour of entertainment, mostly on the first day.
War over water’: drought battle reaches luxury pools of southern France
Warming climate prompts ban on construction of new homes and swimming pools in hilltop Provence villages
The flower-filled medieval hilltop town of Callian, former home of the late fashion designer Christian Dior, has proved so attractive to wealthy incomers that alongside its 4,000-strong population, it boasts 1,000 private swimming pools.
Yet the mayor of the southern French town, François Cavallier, says the influx of second homeowners and tourists must stop — or risk draining the town dry as the region endures a two-year drought.
“We must dissuade people from coming here,” he said. “This won’t last for ever but for now, it would be irresponsible to attract people here and then run out of water.”
The dry weather across a swath of southern France has particularly affected Callian and the other hill towns around Fayence, where visitors have long flocked to enjoy a slice of Provencal art de vivre.
The drought has forced the mayors of nine towns in the area to take drastic measures such as rationing water to maintain supplies and even banning construction of new homes and pools for five years.
These measures have cast a shadow over the area’s key tourism industry, which sustains the economy yet weighs on scarce water resources at the hottest time of year. That tension is only likely to worsen as the climate warms.
In the hill towns, with water levels in the nearby river already at lows not usually seen until July, individuals have been limited to 150 litres of water a day to try to avoid cut-offs when the local population doubles to about 60,000 in summer.
While the nine villages of Fayence are particularly vulnerable thanks to their hilltop geography, the dry winter after the drought of last summer has left the arc of cities along the Mediterranean coast from Perpignan to Nice facing a water crisis.
Farmers and vineyards are competing for water with the campgrounds, hotels, and golf courses that attract tourists. French people who live here full-time mutter about luxurious vacation residences that consume far more water than ordinary homes to maintain their grounds and pools.
The mayor of Châteauneuf-Grasse near Cannes told Liberation newspaper the biggest consumers of water last summer were “VIPs including prime ministers and royalty” — in an apparent reference to Silvio Berlusconi and the former king of Belgium, who have homes there.
Local media outlets and officials call it France’s own “war over water”. Richard Evence, the prefect — or state representative — in the Var region, puts it more diplomatically: “There are conflicts over usage.”
There are real questions over whether this area of southern France, which has experienced decades of strong population growth, can continue on the same development path as climate change pushes temperatures higher.
People move here to achieve the dream of owning a house with a pool and a garden to enjoy the more than 300 days of sun a year, and the economy is largely based on tourism and construction.
Evence said the Var department would soon start a broad study to analyse its water needs and resources in an effort to plan future infrastructure and water use. “There is a real debate over whether we can keep going on as we have done,” he said.
In Perpignan, water scarcity was so acute in March that the church revived a centuries-old tradition of holding a ceremonial procession to pray for rain.
Private swimming pools have become a flashpoint: France boasts 3.4mn of them, second only to the US. Towns where drought has hit hard have begun to impose limits on filling them, while others have banned the sale of above-ground pools.
A hotel industry executive in Nice was pilloried for suggesting that tourists should not be asked to contribute to water savings efforts since it would ruin their fun on the Riviera.
The region’s water infrastructure was conceived largely in the 1950s and 1960s, but is now being tested by the drought and rising temperatures. In addition to natural rivers fed by the Alps, the system relies on man-made canals and artificial lakes built for hydropower by state-backed electricity company EDF, which also serve as reservoirs.
Emma Haziza, a hydrologist and expert on adapting to climate change, said Provence and the Pyrenees Orientales — the area around Perpignan on the border with Spain — had become much drier in recent years, and weather patterns there were changing in ways not yet well understood.
“Today people are waiting for the next rainfall but it’s not going to solve the problem,” she said. “We need a whole new approach to managing water to take less out of the ground.”
Such considerations are what convinced René Ugo, the longtime mayor of Seillans, that the ban on all new construction was necessary.
Since last summer, the town of 2,700 — where a third of the homes are vacation homes or seasonal rentals — has been forced to rely on water delivered by truck. Officials at the water agency tracked each home’s consumption remotely last summer and slapped the worst offenders who flout the caps with flow reducers.
“This year is even worse than last,” said Ugo. “If it doesn’t rain, we will have water outages this summer.”
To cope, the nine towns including Seillans are preparing a system to send text alerts to people to warn them if the water will be cut off. Other constraints are being phased in, such as a ban on washing cars and limits on the hours people can water lawns and gardens.
Not everyone looks favourably on the new approaches, however.
A business owner in the town who declined to be named said he wished the Seillans mayor would stop talking about drought, since it was bad for tourism. Others argue the government should have anticipated the problems and invested more in water infrastructure such as connecting to reservoirs.
Laurent Largillet, the owner of Center real estate agency in Fayence, said the politicians were going too far, and predicted that the construction ban would be challenged in court.
“I think they are being alarmist in the hopes of getting people to slow down their water use,” he said. “But it is very damaging.”
UK energy suppliers: higher margins will keep up heat even as bills drop
Expect anger at the sector’s finances to take a long time to burn out
Energy bills for British households are falling. But flames of indignation at energy company profits still burn.
Energy regulator Ofgem announced this week new caps on the prices per unit of electricity and gas suppliers can charge from July. A typical annual household bill will fall to £2,074. This had previously been £2,500, government subsidies included.
Households will, though, still pay on average 60 per cent more than before Russia’s invasion of Ukraine exacerbated sharp wholesale price rises.
Trade unions and campaigners responded with an attack on Ofgem for not addressing energy companies’ “profiteering”.
The difficulty is that not all energy companies are equal. Even some big companies make a loss on domestic energy sales. Out of three large companies that still strip out their domestic supply earnings — British Gas, EDF and ScottishPower — only the first was in the black for 2022. But other divisions such as electricity generation had a bumper year.
For small companies focused solely on domestic supply, sharp rises in wholesale prices were catastrophic. More than 30 companies that could not access funds from other divisions or external investors went bust from 2021 onwards.
Suppliers complain the cap prevents fair profits. Ofgem has responded with plans to change profit margin allowances. Currently these are set at 1.9 per cent. It plans a new variable element.
Assuming a typical annual bill remains at around £2,100 from October, the amount customers would pay towards suppliers’ earnings would rise by £10 to £47 per customer under the proposals. For British Gas owner Centrica, this could mean additional ebit of £56mn, estimates Jefferies.
Expect anger at the sector’s finances to take a long time to burn out.
Beverly Hills voters reject LVMH luxury hotel on Rodeo Drive
Union opposition dooms Bernard Arnault plan for group’s first US hospitality project
Voters in Beverly Hills, the epitome of wealth and luxury, have narrowly rejected a proposal by Bernard Arnault’s LVMH to build an ultra-exclusive hotel on Rodeo Drive.
The surprising result late on Friday was a setback for Arnault, the world’s richest person, who had chosen Beverly Hills as the first US location for his luxury hotel group. LVMH, which recently became the first European company to reach a $500bn market valuation, splashed out nearly $2.9mn on its campaign to gain approval in the ballot.
The Cheval Blanc hotel proposal was approved by city officials last year. However it ran into opposition by a powerful union that represents 32,000 hotel and other hospitality workers in southern California. The group gathered enough signatures to trigger a referendum election to decide whether the project should go ahead.
The union argued that the development agreement did not set aside provisions for affordable housing in Beverly Hills, where few hotel or domestic workers can afford to live. Beverly Hills, an independent city of about 32,000 people inside LA county, has a median household income of more than $100,000.
Opposition also came from a group of residents who criticised the scale of the planned hotel, saying it would tower over neighbouring buildings and worsen traffic congestion.
“We oppose the monolithic Cheval Blanc Hotel project because it is just too big and tall for our village,” said leaflets distributed by Residents Against Overdevelopment, which said its mission was to “preserve the quality of life in Beverly Hills”.
LVMH argued that the hotel development would generate about $780mn over the next 30 years in tax revenues for Beverly Hills. As part of the deal, the company also agreed to contribute $26mn to the city’s budget and another $2mn earmarked for arts and culture.
“I’m devastated,” said Andy Licht, who oversaw the approval of the Cheval Blanc project as chair of the Beverly Hills planning commission. “It’s a horrible decision.”
A few votes remained to be counted, but the group backed by LVMH to campaign for approval acknowledged late on Friday that it was unlikely to pass.
“If the final vote count confirms the voters’ rejection of our project, we will respect the outcome, and will not bring the hotel project back in any form,” said a statement released by the group, the Yes on B&C Campaign, so named for the letters on the ballot proposal.
Designed by the New York architect Peter Marino, who also oversaw LVMH’s lavish refurbishment of jeweller Tiffany & Co’s flagship store in New York, the Beverly Hills Cheval Blanc represented the group’s latest expansion into the luxury hospitality industry. Plans for the 115-room hotel included space for a 500-member private club, along with high-end restaurant and retail shops.
LVMH is expected to retain ownership of the property and has the option to develop it for other uses, including retail or office space.
Still, it denies the company a chance to capitalise on the growing appetite for high-end hospitality and experiences with a project in Beverly Hills. LVMH and its rivals have poured money into the hospitality sector in recent years, and analysts expect it will be one of the fastest-growing areas in luxury in the coming years.
In 2022, the luxury hospitality market more than doubled in value year-on-year to €191bn despite remaining below its pre-pandemic peak, according to consultancy Bain.
Arnault established the first of the Cheval Blanc hotels in the ski resort of Courchevel in 2006. The high-end chain has now grown to include locations from Paris to the Maldives. In 2018, the group announced it had bought hospitality group Belmond for $3.2bn, which came with a luxury travel portfolio ranging from high-end hotels to the Orient Express train service.
The deal bolstered LVMH’s hospitality portfolio that already included Cheval Blanc and Bulgari Hotels and Resorts. The segment that includes LVMH’s hospitality businesses accounted for only a small proportion of the group’s record €79bn in revenues last year, but after taking a hit during lockdowns it has rebounded strongly since the pandemic.
It Has Been an Ugly Year for Estée Lauder Stock. Better Times Are Coming.
Estée Lauder is having problems—big problems—with everything from sales in Asia to shrinking profit margins. Now, an activist investor is making some noise with an obvious fix. If the cosmetics company’s problems begin to get resolved, the stock could pop.
Barron’s picked Estée Lauder stock (ticker: EL) in July 2022—and it hasn’t gone well. The shares are down 21% since then, with much of the weakness stemming from macroeconomic concerns that the company has no control over, including mobility restrictions in China and a higher U.S. dollar.
We’ve been here before. Similar issues weighed on the company’s outlook in November, and the stock dropped to just under $200. We recommended scooping up shares then because of the long-term sales and earnings growth opportunities in China and in e-commerce sales. After the November problems, they rose back above $270.
Still, Wall Street is growing impatient with the company’s struggles to navigate choppy waters. And with the stock now back below $200—it closed at $190 on Wednesday—billionaire hedge fund investor Nelson Peltz, founder of Trian Partners, is calling for the ouster of CEO Fabrizio Freda.
On the surface, the criticism seems a touch unfair. During its most recent quarter, Estée Lauder reported earnings of 47 cents a share, missing estimates for 51 cents, which the company blamed on a higher-than-expected tax rate. It also lowered its sales guidance for fiscal 2023, which ends in June, to $15.8 billion at the midpoint, down from a previous forecast of $16.7 billion.
The company blamed the dimmer view on a slower-than-expected recovery in travel in certain areas of China, but there were also worries about its ability to get travelers to spend. More problematic, while gross margin remained near 70% in the quarter, operating margins fell to 12% from 19% in 2021, a sign that Estée Lauder hasn’t done much to keep its costs in check.
And that’s where Trian and others see the most opportunity to turn Estée Lauder around. “They should be cutting costs, streamlining plans, doing other things to help that operating margin number—that’s the whole Nelson Peltz argument,” says Stephanie Link, chief market strategist and portfolio manager at Hightower.
Trian and Estée Lauder didn’t return calls for comment. In a memo to employees, Estée Lauder’s board backed CEO Freda, according to the fashion journal Women’s Wear Daily.
Cutting costs, of course, has worked wonders for Facebook parent Meta Platforms (META) and other tech companies, and it could well work for Estée Lauder. Meanwhile, the stock is trading at 30.5 times calendar-year 2024 earnings-per-share estimates of $6.19, above the S&P 500 index’s 18.1 times, but below its five-year average of 35.
The question now is whether Estée Lauder will follow through on some of Peltz’s recommendations. “There’s going to be a huge tailwind for them if they can get these things fixed,” Link says. “Definitely buying on the dip, but you’ve got to have a caveat saying this is not a one-quarter fix.”
The stock isn’t for the faint of heart, but there’s plenty of upside for patient investors.
AI Could Turn Some Tech Winners Into Has-Beens
Even before Nvidia’s blowout earnings report this past week, artificial intelligence was top of the market’s mind. And not just because AI-related stocks have powered most of the rise of the Nasdaq CompositeCOMP +2.19% and broad market gauges, such as the S&P 500SPX +1.30% .
The impact of generative AI, such as ChatGPT, extends far beyond investments, representing a “turning point for humanity—for better and for worse,” according to a provocative series of reports from Deutsche Bank’s Thematic Research team, led by Jim Reid.
Indeed, superintelligent AI could boost economic growth by 30- to 100- fold, comparable to the impact of the agricultural or industrial revolutions, according to a research note by Matt Gertken and Chester Ntonifor, respectively BCA Research’s chief geopolitical strategist and chief foreign-exchange strategist.
That’s the good news. But, they add, AI’s positive impact might be a lot less powerful for technology stocks than for the economy as a whole. Today’s winners might be rendered obsolete by rapid technological changes, leaving many in the dust.
The mere mention of AI exposure has been enough to lift some stocks, according to academic research passed along by Barron’s Jack Otter. The boost, however, could be fleeting, like that in the late 1990s when companies could push up their share prices by attaching “dot-com” to their names. We know how that ended.
What’s different now is the unprecedented ease and rapidity of AI’s adoption. The full impacts of electricity and the automobile weren’t felt for decades. And while spreadsheets, word processors, and graphical user interfaces boosted productivity in the 1980s and ’90s, the BCA strategists point out, it wasn’t until computers were connected via the internet that their true potential was realized. Based on that precedent, they postulate, economywide productivity gains from AI might not be seen until the 2030s.
Moreover, many prognostications are extrapolating AI’s impact linearly. But the BCA report contends its progression is following an exponential curve, meaning that advances could come much faster than expected: “Just as the investment community and the broader public were blindsided by the exponential increase in cases during the early days of the pandemic, they will be blindsided by how quickly AI transforms the world around us,” the pair writes.
In terms of economic and financial impact, this rapid technological change could make today’s AI winners tomorrow’s has-beens, the BCA team argues. Some may fade or be swallowed by survivors, as Sun Microsystems was by Oracle (ticker: ORCL) more than a decade ago. Even giants can founder for years, as Microsoft (MSFT) did early in this century until its current management took over and made it one of the big tech winners underpinning the current market.
When the public perceives a stock to be AI-driven, the impact is immediate, according to a soon-to-be published paper by Arka P. Bandyopadhyay, an assistant professor at the University of Miami, and Dat Mai and Kuntara Pukthuanthong, respectively a doctoral student and a professor of finance at the University of Missouri.
Based on an analysis of news coverage from 1974 to 2020, they found that companies with “AI-ness” showed excess returns over the next month. But those returns faded over the next five to seven months. The AI impact was greatest on smaller companies—some 3% annualized—they determined, a reflection of the difficulty in valuing small-cap stocks. And even before the monster post-earnings move by Nvidia NVDA +2.54% (NVDA), they note, mentions of AI, machine learning, and similar terms have proliferated recently in the earnings calls of the biggest software and semiconductor companies.
From a macroeconomic standpoint, BCA’s Gertken and Ntonifor see artificial intelligence boosting real (inflation-adjusted) bond yields, as a result of faster economic growth. Commodities and real estate could benefit, too. “People will scramble to buy land with their newfound riches, only to discover that it is the one thing that AI cannot produce more of,” the analysts conclude. Even possible “massive deflation” might raise real bond yields, as central banks struggle to increase demand to match rising output, they add.
The great fear is that AI will displace workers, causing significant unemployment. However, historically, technological innovations that increase productivity ultimately have led to rising real wages, Deutsche Bank’s team writes.
BCA cites a recent paper contending that 10% of tasks could be done via AI, affecting 80% of the U.S. workforce, with law, education, information technology, and management consulting most affected. To be sure, that would be painful for those put out of work, but DB posits that artificial intelligence’s widespread adoption might make for better and happier lives.
That is, if humanity survives the transition to superintelligent AI, the chances of which BCA puts at 50-50 by the middle of the century. They note that luminaries, including Tesla’s (TSLA) Elon Musk and Apple (AAPL) co-founder Steve Wozniak, have signed a letter calling for a six-month pause in AI research to develop better safety protocols.
Cybersecurity already is a $188 billion global industry, and companies that add AI safety to their security products will provide an opportunity for investors. There’s always a bull market somewhere, even if the end of humanity looms.
This Economist Thinks a Recession Is Coming. It Could Be a Long One.
Days after Silicon Valley Bank failed, Apollo Global Management Chief Economist Torsten Sløk turned bearish on the economic outlook, flipping from a “no-landing” scenario to expectations of a longer and deeper slowdown than markets anticipate.
Sløk, who worked at the International Monetary Fund earlier in his career, is a veritable walking encyclopedia of economic statistics. On Wall Street, he is known for missives to clients about his near- and long-term economic views, derived from an analysis of government and industry data and academic research—footnotes included.
Barron’s spoke with Sløk on May 10 about the stock market impact of a weakening economy, why a housing recovery might be premature, and the potential risks to the global economy of looming changes in Japan.
An edited version of the conversation follows.
Barron’s: What is the outlook for the U.S. economy now that we have seen more regional bank failures?
Torsten Sløk: The consensus estimates a soft landing, expecting we will have a recession in the third and fourth quarters, with a 0.5% decline in gross domestic product in the third quarter and a 0.5% decline in the fourth. That translates into negative 200,000 in nonfarm payrolls for every month from July to December.
The banking crisis has created a higher risk of a deeper or longer recession. We are leaning toward a hard landing because of much tighter credit conditions and the fear that rates will stay more elevated because the Fed will be worried about inflation being stickier.
Even the consensus estimate implies a lot of job losses. Will it solve the inflation problem?
During the Covid pandemic, immigration declined. But over the past two and a half years, immigration has increased by four million—the same number the Brookings Institution estimates left the labor market because of long Covid.
To put the [inflation] genie back in the bottle involves getting wage inflation to move lower. The labor supply has increased, in particular for prime-age workers, and immigration has increased, which is helpful. But more work has to be done for inflation to fall to a more sustainable level.
Where else do you see inflationary pressures?
Data on the number of prospective new-home buyers, and home-builder and home-buyer confidence, are starting to move higher. Existing—and new—home sales are moving higher. And the average number of offers received for a sold property is going up. Six months ago, it was about two bids on average; now it is more than three. Housing accounts for 40% of the consumer price index. If housing begins to recover, the Fed will be stuck in a difficult situation of stickier inflation.
How does stickier inflation relate to the banks’ recent troubles?
JPMorgan Chase [ticker: JPM] and Bank of America [BAC], combined, make up 26% of all assets in the U.S. banking sector. The 13 biggest banks together comprise 60% of assets. The other 40% are facing higher funding costs, which might be the case well into next year. Over the past several months, banks have been looking at their deposits with very different eyes.
Are they worried about a run on deposits similar to that which brought down Silicon Valley Bank?
In 2013, 39% of people used mobile and online banking. Now it’s 66%, and using an iPhone to bank makes it much easier to shift your deposits elsewhere. There is the risk that bank deposits could disappear quickly.
Banks also face other headwinds. The value of their Treasury and mortgage holdings has declined by so much that many banks are sitting on significant declines in their safe and risk-free assets, and there is probably more regulatory scrutiny coming to regional banks.
I started my career at the IMF. The first thing you learn is that banking crises normally happen in a bad economy because the banks start losing money on loans to consumers, corporates, and commercial real estate. What is so unusual today is that with the collapse of the 14th-largest and 16th-largest banks [ First Republic Bank and Silicon Valley Bank, respectively], we have what I would describe as a banking crisis in a good economy—and we are about to enter a bad economy.
What are the implications as the economy weakens?
Asset prices are already down in banks’ most liquid [holdings]. If there is a recession, there is risk to the illiquid part due to credit losses related to consumers and corporate business.
Small banks—Nos. 26 to 4,500 in size—make up roughly 37% of all lending in the banking sector. Banks’ willingness to lend to consumers isn’t quite down at 2008 levels, but the trend is not our friend.
If the sources of financing from high-yield markets, primary issuances, and regional banks have essentially dried up, private credit and private capital have been stepping in and acting as a stabilizer by lending.
Have private markets felt a strain yet from the rapid increase in interest rates and a slowing economy?
As interest rates rose, technology and growth companies suffered because long-duration cash flows are highly sensitive to the federal-funds rate. In private markets, it’s exactly the same. Many tech companies and companies with levered bets on low interest rates are now suffering. The total value of venture capital is down 60% since the Fed started raising rates, according to Refinitiv. The crunch in tech—in the Nasdaq, venture capital, and growth stocks—will continue because the cost of capital is likely to stay high.
When do you expect interest rates to head lower?
[Inflation] went from 9% last June to 5% today. Getting inflation from 5% to 2% is going to be a lot harder.
The market expects the Fed to cut rates in September. It will probably take until the middle of next year before it can cut rates because inflation is so sticky and the Fed’s mandate from Congress is to get inflation down to 2%.
Things that are interest-sensitive are likely to remain negatively impacted. That means the housing recovery is probably premature. The Fed will simply not allow the housing market to recover if that involves inflation moving higher. We are likely to have stagflation for the next three quarters—elevated inflation and a contraction in GDP.
What types of investments are most at risk?
Lower-rated credits, in particular bonds rated triple-C and high-yield [securities], will be hurt by the double whammy of high rates, which means a higher cost of financing, and low growth, which means lower earnings and lower profitability.
Should you buy the S&P 500 today? No, because you can probably buy it cheaper in three or six months. The [positive] outlook for 12-month forward earnings per share for the S&P 500 is stunning,given the drop in expectations for real growth and consensus expectations for a recession.
But in 12 to 24 months’ time, these things will blow over. Long-term investors should do their homework and look at the things that are beaten up.
Commercial real estate is losing value. What is the economic impact?
Within real estate investment trusts, offices haven’t been doing well but industrial and warehouse REITs still have positive returns. This isn’t like 2008, when the problem was uniform and residential real estate made up 7% of GDP.
Commercial real estate today accounts for only about 2.5% of GDP. In 2008, GDP declined 3%. GDP will decline over the next three quarters by roughly half a percentage point. This recession is going to be much milder than in 2008, although it could be longer.
How will we know when the worst is over?
Once the vacancy rates of commercial properties and the price per square foot begin to turn around, that will be a bullish sign for stock market investors and the economy. The problem is that the vacancy rate is still going up, and the price per square foot of office space is down 30% from the peak.
What else should investors monitor?
TSA [Transportation Security Administration] data on how many people are flying on airplanes; how many are going to movie theaters and Broadway shows and staying at hotels. When consumers have burned through their savings and don’t have money to do all these things, that will be the business-cycle inflection point we’re waiting for.
Restaurant performance has shown some signs of weakness. Jobless claims are gradually moving up. Tech workers are normally high-paid workers and may not apply for unemployment benefits, so they might not be included. Since that’s where we have seen most of the layoffs, the unemployment rate might truly be at a higher level. There are some early signs the services are seeing a slowdown. Investors shouldn’t underestimate the Fed’s commitment to get inflation back to 2%, and with that will come the risk of a sharper slowdown.
What are you monitoring beyond the U.S.?
It’s important to pay attention to statements from the Bank of Japan about yield-curve controls, which have kept Japanese interest rates near zero for seven years. Since 2016, the Bank of Japan said it was going to buy an unlimited amount of [Japanese government] bonds to make sure that 10-year rates didn’t go up.
With rates in their own backyard very low, Japanese insurers and banks invested in U.S. Treasuries, U.S. investment-grade bonds, and European bonds. If over the next six months Japan says it will now allow interest rates to rise, the risk is that Japanese investors will begin to repatriate money because yields on Japanese government bonds will be moving higher.
What are the ripple effects?
Japan is the biggest foreign holder of U.S. Treasuries, with more than $1 trillion. If Japanese investors begin to sell those Treasuries, U.S. Treasury rates could rise and U.S. credit spreads could widen. Even if Japanese investors do nothing, there’s the risk the rest of the world could say they want to offload their U.S. Treasury bonds and credit if Japan is about to do so. This is an event risk not appreciated in financial markets.
Could Japan’s move negate the need for further Fed tightening?
Yes. But there is the risk of a substantial and uncontrolled move [in rates] that poses all kinds of risks to the global economy.
Thanks, Torsten.
Hedge Funds Are Bullish on Their Stocks but Bearish on the Market
Hedge funds are bullish on their individual stocks, but bearish on the overall market. In the first quarter, they sold banks and technology stocks, while adding to defensive sectors like health care.
Those are the highlights from a Goldman Sachs analysis of holdings of 740 hedge funds worth a combined $2.2 trillion at the end of March. Within 45 days of the end of each quarter, hedge funds must report their portfolio holdings to the Securities and Exchange Commission on a regulatory form known as a 13-F.
Collectively, hedge fund managers appear to be betting on 2023 being a so-called “stockpickers’ market,” per data from Goldman Sachs.
“Hedge funds have little conviction in market direction but high confidence in their stock picks, especially in long portfolios,” wrote Goldman Sachs strategist Ben Snider. “…Hedge funds carry large net short positions in equity futures and [exchange-traded funds,] but short interest for the typical stock remains close to the historic low at just 1.7% of float cap.”
It has been a top-heavy market so far this year, and hedge funds have participated. Their most popular positions are Microsoft (ticker: MSFT), Amazon.com (AMZN), Meta Platforms (META), Alphabet (GOOGL), Uber Technologies (UBER), Apple (AAPL), and Nvidia (NVDA). Those make up the top of Goldman Sachs’ “Hedge Fund VIP” basket, which includes the stocks that are most frequently found in hedge funds’ top-10 holdings.
On a sector level, hedge funds added to their defensive exposure in the first quarter. Healthcare—which was already the group’s largest overweight relative to the Russell 3000 index of most U.S. stocks—saw the biggest increase in holdings, followed by consumer staples and utilities.
Hedge funds had a collective 25.2% of their portfolios in healthcare stocks at the end of March, versus the Russell 3000’s 13.5% weight in the sector. Despite the first-quarter inflows, utilities and consumer staples remain modest underweights relative to the index. Other overweights include cyclical industrials and materials stocks, but those make up a relatively small percentage of both the index and hedge fund portfolios.
Tech stocks were hedge funds’ greatest underweight relative to the index, at 13.9% versus 24.1%, respectively. The group was the biggest source of selling in the first quarter. Financials were the second-largest underweight to the Russell 3000, with regional banks also seeing outflows during the sector’s turmoil.
Hedge funds saw some bargains in the financial sector in the first quarter, however. Charles Schwab (SCHW), BlackRock (BLK), and JPMorgan Chase (JPM) were among the top new buys in the first quarter—judged by the increase in the number of hedge funds owning the stock.
Other top buys among hedge funds in the first three months of 2023—a group Goldman calls the “Rising Stars”—were National Instruments (NATI), Walmart (WMT), GE Healthcare Technologies (GEHC), Honeywell International (HON), Norfolk Southern (NSC), Estée Lauder Companies (EL), and Pfizer (PFE). Since 2002, the stocks in that basket have gone on to beat their sector by an average of 0.59 percentage point in the following quarter, according to Goldman Sachs.
The reverse trade has also worked: Stocks with the greatest decline in the number of hedge-fund shareholders in a quarter have lagged behind their sector peers by 0.60 percentage point over the next quarter. In the first quarter, the list of “Falling Stars” included Qualcomm (QCOM), DXC Technol ogy (DXC), Textron (TXT), Bunge (BG), Juniper Networks (JNPR), Southwest Airlines (LUV), Welltower (WELL), Dominion Energy (D), Vertex Pharmaceuticals (VRTX), and Cisco Systems (CSCO).
Italy’s Market Likes the New Prime Minister. She’s Showing Her Moderate Side.
Giorgia Meloni wasn’t elected to comfort the afflicted.
The Italian prime minister, who swapped her trademark white suit for jeans this past week to wade through flooded villages in the Emilia-Romagna region, swept to power last autumn on a right-populist platform of containing immigration, slashing taxes, and sticking it to the overbearing eurocrats in Brussels.
She hasn’t done much on any of these fronts. “So far, Meloni has been much ado about nothing,” says Kaspar Hense, a senior portfolio manager in fixed income at RBC BlueBay Asset Management.
That’s a good thing, from markets’ point of view. The yield spread of Italian 10-year bonds over German bunds, a key metric of investor confidence, has tightened by 45 basis points since Meloni’s Sept. 26 election, to below 200.
Standard & Poor’s and Moody’s lately maintained Italy’s credit rating at the lowest investment-grade rung, rather than reduce it to junk.
The iShares MSCI Italy exchange-traded fund (ticker: EWI) has rallied with the rest of Europe, gaining 40%. No. 2 bank UniCredit (UCG.Italy) has led the surge, rising by two-thirds.
Candidate Meloni promised 260 billion euros ($280.4 billion) in tax cuts, Hense says. Her first budget delivered €10 billion. Firebrand Meloni once signed a manifesto declaring “no to Europe.”
In office, she has toed the European Union line on Russia, and held off on pledges to turn back migrants from Italy’s shores.
“At a European level, she has sought to position Italy as a constructive mainstream partner,” says Eoin Drea, senior researcher at the Wilfried Martens Centre for European studies.
That’s all bowing to reality. With national debt around 140% of gross domestic product, Italy can’t afford to sacrifice tax revenue in a supply-side experiment. Playing nice with Brussels is only sensible when the country is in line for up to €200 billion from a European Recovery Fund raised postpandemic. Italy’s suffering from Covid-19 makes it the top potential recipient.
The Recovery Fund cash, due to be doled out by 2026, could add 4% a year to Italy’s GDP after decades of anemic growth, Hense calculates. If only the country can figure out how to spend it.
Previous governments proposed nonessential projects like a new soccer stadium in Venice, sapping Brussels’ confidence, Drea says. Meloni has floated a build-back-better shift to green energy and transportation. Chances of a credible pipeline by a June 30 deadline still look slight.
Success in drawing down recovery funds could give Meloni a shot at bigger structural changes, says Matt Gertken, chief geopolitical strategist at BCA Research.
Voters like the breath of fresh air she brings as Italy’s first female prime minister, and one of its youngest, at 46. Her coalition holds some 60% of both houses of parliament, and trounced a divided opposition in regional elections around Rome and Milan in February.
So, her government might last longer than most of its 67 predecessors since World War II. EU largess could provide fiscal space for her tax cuts.
Her personal example might get more Italian women into the workforce, a structural shot in the arm. Female labor participation languishes at 40%, compared with 51% in France and 56% in Germany.
Not that Gertken is betting on it. “Basically, Italy is hoping to muddle through and avoid a direct clash with Brussels,” he says. Hense predicts that the bond rally has peaked, and he has turned “cautious” on Italian paper.
“Muddle through” isn’t the worst that was expected from Meloni’s first half year, though.