TheChek News Flow

With the prices of flour, butter, and eggs skyrocketing, the headwinds facing boulangeries in France’s capital highlight why the European Central Bank is facing a tougher struggle than the Federal Reserve.

A short march from the Gare du Nord station in Paris’s 9th Arrondissement, Charles Ye and Maeva Manchon wake early to follow their passion—baking baguettes, croissants, and cakes at the boulangerie they started three years ago.

Sipping shots of searing-hot espresso, they say the problem is that runaway inflation means they are no longer able to pay themselves with the bakery’s earnings. Since Russia invaded Ukraine last year, the cost of electricity has jumped almost four times. Flour, butter, and eggs are all about 50% more expensive, according to the bakers.

“Prices for everything went up, and they’re still going up,” says Ye from the office of his Union Boulangerie. “When it all started, we thought, OK—it’s temporary, Ukraine, we accept it. But now it’s becoming normal.”

There are plenty of complaints about rising prices in the U.S. But for Parisian baguette bakers, it has become an existential crisis. Input costs are rising much faster than Manchon and Ye can raise prices for their goods. It’s a squeeze that is hitting France’s 33,000 bakeries particularly hard.

Inflation in the euro zone—the 20 countries in the European Union that share the currency—looks to be harder to tackle than it is in the U.S. The biggest reason: The European Central Bank started raising interest rates later than the Federal Reserve, fueling expectations that inflation will last for longer—which could become a self-fulfilling prophecy.

It’s the expectation that prices will probably keep rising that is most dangerous for central bankers, whose job it is to keep the inflation rate at about 2%. While rates are retreating now, there’s reason to believe it will take ECB President Christine Lagarde longer to win the battle against price rises than it will for Federal Reserve Chairman Jerome Powell.

Both were caught a bit off guard by inflation’s return after more than a decade of weak price gains. The emergence from the Covid-19 pandemic provided the spark, but it was Russia’s invasion of its neighbor in February 2022 that poured fuel on the fire. The euro zone’s inflation rate peaked at 10.6% in October and is now at about 7%, compared with about 5% in the U.S.

The problem for central banks is they don’t have direct control over the cost of all the things that go in the basket of goods and services measured to calculate inflation. In the short term, there is absolutely nothing the central bank can do to lower the price of electricity or flour.

Broadly speaking, when the central bank wants to rein in price increases, it raises interest rates to limit the amount of money in the economy. With less money around to spend, companies can’t charge as much, thus inflation cools.

That’s the theory. In practice, there are multiple channels through which monetary policy works. The key point is that the central bank has influence on inflation only at a very early stage in its pipeline. Academics reckon it takes a year or two for rate hikes to do their job.

The other key thing is that monetary policy really only affects the demand side of the economy—how much people can buy. It’s powerless to change the supply side—how much is available for sale.

These constraints create a challenge for central banks. When the prices of things such as energy go up suddenly (supply-side issues that policy makers can’t control), workers respond by asking for higher pay to maintain their standard of living. Higher pay lifts the demand side of the economy, strengthening inflation for the longer term, ultimately forcing central banks to raise interest rates higher than they would otherwise in an effort to get inflation back under control.

The case of Union Boulangerie makes the point. As well as having higher costs for power and ingredients, Ye and Manchon are raising wages for their employees by about 10% and expect to have to do so again next year and the year after, in no small part because everyone expects inflation to stick around. Before, wages were going up only 4% to 5% a year.

The same thing has played out on a larger scale. Wage growth has picked up substantially on both sides of the Atlantic, but might be more likely to stay stronger in Europe than in the U.S. That’s down to labor unions, more powerful across the pond, bargaining on workers’ behalf.

The Boulangerie Castellane, an artisan bakery that handmakes pastries, cakes, and tarts using traditional techniques, can be found close to the famous Palais Garnier opera house.

Wiping away the crumbs of meringue and mille-feuille from the display case, Castellane’s Jonathan Coscas tells Barron’s: “If prices are going up, we have to pay more if I want to keep my employees. But the bigger worry is that I’ll lose my customers.”

There are other reasons why inflation may prove stickier in Europe. The war in Ukraine is on its doorstep and is still limiting gas supplies, keeping energy prices higher for longer. Governments in France and elsewhere are supporting companies and consumers with subsidies to get through the price spike, but that can also add to inflation pressures by giving people more money to spend.

Across the Seine from Boulangerie Castellane—in the shadow of the Eiffel Tower—is Boulangerie Patisserie Coudrier Geffroy, run by Freddy Coudrier.

“Energy is the big problem,” he says as he prepares lunchtime wine for guests at the bustling cafe attached to his bakery. “I’ve raised my prices by a few cents on some products, but not yet on the baguette. The competition is tough.”

Erik Norland, senior economist at CME Group in London, points out another factor in Europe—countries there are hugely increasing military spending in a way the U.S. isn’t. Defense spending is particularly inflationary because the goods produced aren’t directly consumed in the economy.

What’s more, the ECB started raising rates later than the Fed, waiting until July last year before starting its campaign, compared with last March for the Fed. While both started with rates around zero, the Fed has also moved them up much further. Given the lags between higher rates and the impact on inflation, it’s reasonable to think it will take longer for European hikes to kick in.

Moreover, the ECB may not be able to hike as much as the Fed because of how the euro area is set up. The ECB sets interest rates for 20 nations, all with different economic situations and needs. One reason it started so late might be because the last time it lifted rates, it caused huge problems for some countries that had trouble rolling over their bonds at higher rates. The ECB has introduced new tools to prevent similar issues from happening again, though it is well aware that there is always a risk of surprises.

“Central banks tend to raise interest rates until something goes wrong,” says CME’s Norland. “But it’s very possible that here in Europe, they haven’t yet done anywhere near enough to contain inflation.”

The good news is that, eventually, higher interest rates will conquer inflation. It’s painful and takes time, but the track record from the 1970s and early ’80s is the evidence. It just might take a little longer to get there in Europe than in the U.S.

Didier Boudy, president of Mademoiselle Desserts, which supplies cakes to bakeries in France, the Netherlands, and the United Kingdom, said his company is still raising prices as a matter of survival for the business. But he is hopeful that things will change.

“It has been a tsunami of inflation,” he says. “If we were not passing along price increases, we would have gone bankrupt very quickly. Long term, we hope it will ease off and we can reduce prices for some things. But it’s far too early to do it today.”

Meanwhile, bakers in Paris will feel poorer. Manchon and Ye say they’re still happy they are able to make a living from the work that is akin to a vocation, even though inflation is eating up most of their earnings.

“We can be like this for one or two years,” Manchon says. “But maybe at some point I won’t like working for almost nothing.”

Pop quiz: Name a company that doubled its earnings during the pandemic but now trades more cheaply than it did at the start of 2020, even as sales hit new records.

If you didn’t say Thermo Fisher Scientific (ticker: TMO), it may be because you forgot about this Covid beneficiary. Or because you never knew its name at all, even though its products help researchers create new drugs and tests that save lives. In either case, it’s worth getting to know now.

The Waltham, Mass., firm is the global leader in laboratory equipment, analytical instruments and technologies, and specialty diagnostics tools that are used across the healthcare, pharmaceutical and biotech industries. That positioned Thermo Fisher to reap huge benefits from Covid-19 testing, allowing earnings per share to jump from $12.35 in 2019 to more than $25 in 2021.

As the pandemic fades, earnings have dipped, taking the stock with them. But the slump shouldn’t last long.

“A lot of investors are too focused on what Thermo Fisher did during Covid and that it’s now slowing down, but that’s a minute part of the business,” says Craig Sarembock, principal at Bartlett Wealth Management, which owns the stock. “It’s unimportant to me, given that the company already provided really good guidance.”

In early February, Thermo Fisher offered full-year guidance when it reported better-than-expected fourth-quarter results, saying it expects to earn $23.70 a share in 2023 on revenue of $45.3 billion. That was ahead of the average analyst estimates for earnings of $23.07 a share and revenue of $43.8 billion. Still, the projected per-share profit is below 2021’s record $25.13.

The analysts’ consensus calls for Thermo Fisher to surpass that all-time high again in 2024, with earnings per share of $26.70. But the two-year decline has spooked investors, with the shares falling 14% since the end of 2021 as the company has faced difficult comparisons to the pandemic boom.

The upshot: The stock now trades at 24 times forward earnings, about its five-year average and below its pandemic high of 26.6 in December of 2021. Yet consensus estimates call for earnings to keep jumping–reaching more than $30 a share in 2025–while metrics like free cash flow and return on equity remain well above prepandemic levels. The average analyst price target is above $650, nearly 15% higher than Monday’s close of around $574.

“This is a stock to own for the long-term, and in terms of valuation, it certainly looks attractive for new purchasers now,” says Sarembock.

The shares also look appealing in the light of recent market turmoil: Although Thermo Fisher is often classified as a growth stock, it enjoys steady recurring revenue among loyal customers that often are doing intricate research and development.

“It’s exposed to the attractive dynamics in healthcare, where the process for creating drugs is more complex, tool intensive and tool sensitive,” says Sarah Kanwal, director and equity analyst at Crestwood Advisors, citing newer products like biologics and larger molecule drugs that are produced differently. “Thermo Fisher is the picks and shovels behind that trend. It’s agnostic to specific drugs or who the winners and losers are.” Crestwood owns the stock.

Or as Sarembock puts it: “No matter what [healthcare] companies are doing, they need Thermo Fisher for their labs.”

The confidence that comes with supplying a number of growing healthcare end markets—thanks to an aging population and increasing treatment options—was on display in the company’s most recent results. Chief Executive Marc Casper used phrases like “crushed it” and “phenomenal performance.” The company also boosted its dividend by nearly 17%, and its guidance implies 7% core organic revenue growth, excluding acquisitions.

Of course, it’s hard to talk about Thermo Fisher without talking about its acquisition strategy, which has helped it expand and diversify its revenue in terms of customers, geographies, and new products and business segments.

“Ten years ago, this was a different business, and much more instrument focused. If we had a recession then, it could have been a much bigger [problem],” says Douglas Kelly, partner and portfolio manager at Williams Jones Wealth Management, which owns the stock. “Today it’s not that cyclical of a business unless we get into a really nasty downturn.”

Thermo Fisher pulled off all the dealmaking without running up its debt ratios. In fact, net debt to earnings before interest, taxes, depreciation and amortization, or Ebitda, stood at 2.2 times at the end of last year, its second lowest level since 2013. Total debt to Ebitda, at 2.9 times, is well below the prepandemic period dating back to 2013.

Moreover, free cash flow is expected to reach $7.2 billion this year, nearly double where it stood in 2018. That gives the company flexibility to potentially pursue other acquisitions, and to increasingly return more cash to shareholders in the form of dividends and share buybacks, as it has been doing in recent years.

“This is the kind of business in our sweet spot,” says Kelly. “Good returns and a management team that does the right things with that cash. That’s the formula.”

Sounds simple enough, just like being diligent about diet and exercise. Though of course both are easier said than done. Until more of us learn to take that advice, and overcome numerous other healthcare hurdles, Thermo Fisher will have plenty of room to grow.

The pace of activist campaigns has cooled against the challenging macroeconomic backdrop of 2023, but companies should remain vigilant to avoid ending up in an activist’s crosshairs.

That’s because market slumps and economic downturns can expose weaknesses at specific companies, handing activists blueprints to plot changes. In more-robust economic times, companies may have an easier time masking their troubles with surging cash flows. When the tide goes out, however, it’s harder to hide blemishes—especially if a company fails to keep up with peers.

Typically, activists seize upon companies that are underperforming in four areas: sales growth, valuation, net margin, and two-year stock performance, according to new analysis from Goldman Sachs, which examined component companies in the Russell 3000 index over a 17-year period. In a report, the bank identified 116 companies with market capitalizations of more than $5 billion that could attract activist attention, including retailer Best Buy BBY +1.35% (ticker: BBY), trading app Robinhood Markets HOOD +0.34% (HOOD), and industrial giant 3M MMM +0.84% (MMM).

There were 27 campaigns launched during the first quarter of this year, according to Goldman’s tally. That marks a 24% drop from the fourth quarter of 2022, and it also lags behind the pace of campaigns for all of last year, which totaled 148.

Despite fewer campaigns this year, activists have certainly been bold, targeting large-cap companies such as Walt Disney (DIS) and Salesforce (CRM). It’s all the more reason for companies to be wary.

S&P500 rises 8 per cent this year, but vast majority of gains were delivered by just seven stocks

A small number of tech companies are driving an ever-increasing share of the US stock market’s gains, prompting concerns among investors about the sustainability of the rally.

The S&P 500 has risen 8 per cent so far in 2023, but 80 per cent of the increase has been driven by just seven companies, according to Bloomberg data. Apple and Microsoft have led the way, contributing around 40 per cent of the index’s rise as they added more than $1.1tn in combined market capitalisation.

The trend has been growing for several months. However, the gulf between the small number of winners and the rest of the market widened over the past week as strong tech earnings contrasted with mixed results in other sectors and downbeat economic data.

Stuart Kaiser, head of equity trading strategy at Citi, said many investors were growing nervous about the fragility of the rally, but were reluctant to pull back and risk missing out on further gains.

“People are considering diversifying because the [tech] outperformance has been so wide, but we’re not seeing people pulling back yet”, he said.

Big tech has benefited from enthusiasm about generative artificial intelligence, along with a belief that the sector would be relatively insulated from an economic slowdown, and expectations that the Federal Reserve is approaching the end of its cycle of interest rate rises. Many long-only investment funds are also rebuilding their positions from a low base after selling huge amounts of tech stock last year.

Nvidia, which designs high-powered chips crucial to the AI boom, has been the third-biggest contributor to the S&P’s rise, followed by Facebook owner Meta, which has rebounded from a rough 2022 to double in value so far this year. Next was Google owner Alphabet — another large investor in AI — along with Amazon and Tesla.

The stocks have gained an average of 44 per cent so far this year, compared with a 2 per cent increase in the equal-weighted S&P 500.

Sentiment about the broader market has been dominated by concerns about the economic outlook. Companies in the benchmark index are on track to report their second consecutive quarter of earnings declines, and data released this week showed economic growth slowed dramatically in the first quarter, to an annualised rate of 1.1 per cent.

“We understand why risk assets have done better through the winter,” Sonja Laud, chief investment officer at Legal & General Investment Management, said in an interview. US inflation started to back down towards the end of last year, then as 2023 got under way, Europe dodged an energy crisis and China emerged from its zero-Covid lockdowns.

“That meant we had a far better start to the new year,” Laud said. “But there’s no evidence since the 1970s that a rate hike cycle, especially as aggressive as the one we have seen, won’t lead to a recession, a financial crisis, or both. Why would this be different?”

That has left LGIM shying away from risky assets in equities and credit, and leaning more towards government bonds. Laud said the firm had asked every one of its fund managers to scour their portfolios to look for weak links that might struggle if the current slowdown turns more severe.

The cautious stance is typical among large money managers. Citi’s Kaiser said: “You can earn so much yield keeping money in cash that the hurdle rate or bar to put money into equities is quite high”.

Markets have already started to lose some of their steam. In all of April, the S&P gained 1 per cent or more in a day only twice — a tally that has gradually shrunk from six days in January. The index added 1.5 per cent for the month, the second-worst month of the year so far.

With so much of the strength resting on a small number of companies, any bad news for the tech sector — such as the Fed deciding to keep rates high for longer than investors expect — could have a disproportionate impact.

Still, some are hopeful that the rest of the market will be able to start catching up with the winners, rather than the other way round.

“Once you have extreme readings like leadership in a few stocks, that’s usually signalling the fact that things are already quite bad . . . it’s a sign more often that the market is bottoming,” said Denise Chisholm, director of quantitative market strategy at Fidelity.

“I understand the behavioural bias of people intuitively waiting for the last shoe to drop, but the data doesn’t support it when you look at the history of equities.”

Services and construction still show expansion, indicating uneven recovery across post-Covid economy

China’s manufacturing activity contracted in April, official figures showed, as global demand for goods slowed and Communist party leaders warned that a post-Covid recovery in the world’s second-largest economy had yet to gain solid footing.

The National Bureau of Statistics’ purchasing managers’ index fell to 49.2 points compared with 51.9 in March, falling below analyst expectations of 51.4 in a Reuters poll.

China’s non-manufacturing purchasing managers’ index, which includes the services and construction sectors, was 56.4, down from 58.4 in March but still showing expansion since President Xi Jinping ended the country’s economy-constraining zero-Covid policy in December.

A reading above 50 indicates expansion compared with the previous month, while one below 50 means a contraction.

“This is a mixed PMI report and suggests that China’s post-Covid recovery has somewhat lost steam and calls for continued policy support,” said Zhou Hao, chief economist at Guotai Junan International, a Hong Kong-based brokerage.

In a sign of China’s economic recovery from last year, state media reported forecasts that about 240mn passenger trips would be made during this week’s five-day May Day holiday, higher than in 2019 before the pandemic.

But while consumer activity is rebounding from a low base, the rest of the economy has deeper challenges, with the property sector still limping after a government crackdown and export markets fading as advanced economies weaken.

In March, China’s PMI showed a similar picture, with growth in manufacturing dipping despite a recovery in exports, while other sectors showed a rapid rise in activity, indicating an uneven recovery.

“Economic growth has exceeded expectations . . . and China’s economy is off to a good start,” the Communist party’s politburo said in a meeting on Friday. But the “endogenous driving force” of the economy was “still weak and demand insufficient”, state media Xinhua reported the bureau as saying.

Zhao Qinghe, senior statistician at the NBS, said in a statement on Sunday that the manufacturing PMI’s contraction was “due to factors such as insufficient market demand and the high base formed by the rapid recovery of the manufacturing industry in the first quarter”.

Production expanded slightly, but sub-indices for new orders, raw material inventories and employment in the manufacturing sector all fell.

Goldman Sachs said in a note that the non-manufacturing index’s performance was “still solid but lower than market expectations, suggesting continued recovery in construction and services sectors but at a slower sequential pace”.

Part of the recovery in construction was driven by infrastructure, the NBS said. Beijing has used infrastructure to stimulate growth following the property sector’s collapse over the past two years.

The politburo signalled more support for economic recovery and called for targeted “proactive fiscal policy” and “prudent monetary policy”.

“The incomes of urban and rural residents should be increased through multiple channels . . . and the consumption of services in sectors such as culture and tourism should be boosted,” Xinhua reported the politburo as saying.

Nomura forecast that China’s export industries would remain under pressure due to “the ongoing global tech downturn, heightened global financial market turmoil and deteriorating US-China trade relations”.

“The export downturn will likely continue to hinder the recovery of employment and manufacturing investment,” it said in a report prior to the PMI data release.

SVB’s implosion highlights the destabilising impact of quantitative easing

The recent failure of Silicon Valley Bank combined two ingredients: excess deposits and losses on assets, even in securities such as Treasury bonds that are ordinarily considered “safe”.

SVB did not have adequate liquidity to tolerate a bank run and did not have adequate solvency to meet its liabilities. Emphatically, however, the failure did not occur because there was too little liquidity in the banking system as a whole. It occurred because there was too much.

At the end of 2022, the US banking system had $18tn in domestic deposits, including an estimated $10tn of deposits insured by the Federal Deposit Insurance Corporation. That meant there were $8tn of deposits that exceeded the FDIC insurance limit.

Those destabilising excess deposits are there because in more than a decade of “quantitative easing”, the Federal Reserve took $8tn of bonds out of the hands of the public and replaced them with bank reserves.

Conceptually, one can think of a customer deposit as being “backed” either by reserves that the bank holds with the Fed or by assets such as an IOU that the bank received in return for a loan it made.

By buying trillions of dollars of bonds under quantitative easing, the Fed also in effect pushed trillions of dollars of deposits into the banking system, backed by newly created reserves rather than bank loans. Yet despite the most aggressive monetary expansion in history, the growth rate of US commercial bank loans (business, consumer, real estate) averaged just 3.4 per cent annually between 2008 and 2022, easily the slowest growth rate in data since 1947.

In 1852, Walter Bagehot wrote: “John Bull can stand many things, but he cannot stand 2 per cent.” For more than a decade, quantitative easing stretched that thesis to extremes.

Once the Fed created $8tn in base money, it ensured that, in equilibrium, someone in the economy would have to hold it indirectly as bank deposits, indirectly in money market funds or directly as physical currency.

All of the increased reserves — and associated bank deposits — earned nothing. Someone had to hold them, and nobody wanted to. The moment any holder attempted to put the money “into” a security, the seller of that security took the money right back “out.” Long-term securities, including Treasury bonds, were driven to record valuations because yield-starved investors, banks and pension funds could not tolerate the perpetual zero-interest rate world created by central banks.

Having engineered a toxic combination of excess bank deposits and yield-seeking speculation, the Fed ensured that instability would follow.

As I wrote in the Financial Times in January 2022, by relentlessly depriving investors of risk-free return, the Fed has spawned an all-asset speculative bubble that may now leave investors with little but return-free risk.

Investment losses have emerged since early 2022, both because inflation pressures forced the Fed to normalise rates after 13 years of zero-rate financial repression and because extreme valuations are never sustained indefinitely. The Fed can no longer operate monetary policy without explicitly paying interest to banks on the liquidity it created.

Sudden banking strains in the US and Europe, the British pension crisis last year, equity market losses — all these are merely symptoms of an unwinding bubble. The Fed itself would technically be insolvent if it was to mark its assets to market value.

In response to the insolvency of SVB, the FDIC took the bank into receivership, wiping out the stockholders and unsecured bondholders. This was, and remains, the proper approach to bank insolvency. The largest bank failure in US history — the 2008 failure of Washington Mutual — is unmemorable because it was also resolved in this manner. The FDIC took receivership. Stockholders and unsecured creditors lost because they were supposed to lose in this situation. Depositors lost nothing.

While the decision by the FDIC to cover uninsured deposits remains controversial, enhanced deposit insurance, funded by higher fees, may become necessary for a period of time. It is not the fault of savers that the banking system is drowning in excess deposits.

Savers, in aggregate, are captive victims of the Fed’s dogmatic “ample reserves regime”. Until it winds down this misguided experiment, global policymakers will continue their scramble to create new special programs, acronyms and emergency facilities to manage the whack-a-mole world of complications it has produced.