Dear Friends,
The second quarter earnings season has been ongoing over the last four weeks and so far, good news has turned out to be bad news. For the S&P 500 companies that have reported, the majority have announced results that met or exceeded expectations. So why has the S&P 500, Nasdaq, and Dow Jones Industrial Average index experienced a drawback? Find out in this week’s newsletter.
Economy, Geopolitics, and Commodities
1. Inflation and Housing Costs Are Set to Turn a Corner
Americans are paying more to rent or insure their homes than a few years ago and much more to buy one with a mortgage, but there’s a silver lining in that hardship: A cool-down could help convince the Federal Reserve to pause its series of interest rate hikes. On August 10th, a report from the Labor Department on inflation showed that more than 90% of the increase in prices in July came from shelter. Other big contributors were things like motor vehicle insurance. The overall rate of inflation in July was in line with the expectations of economists polled by The Wall Street Journal, rising 0.2% on a seasonally-adjusted basis—the same as June. That puts the 12-month increase at 3.2%, down from the multidecade peak of 9.1% hit in June 2022.
As the Fed mulls its next steps, there will be two features of the Labor Department’s consumer-price index calculation that pull Fed rate-setters in opposite directions. On the hawkish side, the so-called base effect will mean that, even if the monthly figures are fairly tame, they will be compared with year-ago figures that contributed to the sharp cooling in inflation from the June 2022 peak. That could keep the 12-month increase well above the 2% target the Fed would prefer before it declares victory. But housing costs could lead to the rescue and even allow for some easing by next year. A letter this week from the Federal Reserve Bank of San Francisco notes that all sorts of private sector indicators of rents and house prices are slowing. These include things such as Zillow’s Home Value Index, the Apartment List Vacancy Index, and the S&P/Case-Shiller U.S. National Home Price Index.
If that collection of private sector data is to be believed, and if those measures’ past ability to predict government shelter prices was no fluke, then shelter costs are headed down—way down. The model sees shelter’s contribution to 12-month CPI going from the high single digits to possibly negative by the middle of next year in what the letter’s authors say could be the most severe contraction in that component of inflation since the 2007-2009 financial crisis. Needless to say, Fed-watchers who haven’t crunched the numbers as finely are aware of the sharp slowdown and the fact that shelter makes up more than 40% of the “core” CPI basket that is most closely watched by government economists. The latest implied odds from CME Fed Watch give about one-third odds that the Fed’s overnight rate will be lower by January and about 50% odds they will be in the same 5.25% to 5.5% range as today.
2. How U.S. and China Are Breaking Up in Trades
A deepening confrontation between the U.S. and China is eroding trade ties between the world’s two largest economies, with goods from China accounting for the smallest percentage of U.S. imports in 20 years. Instead, buyers are turning to Mexico, Europe, and other parts of Asia for wares ranging from computer chips and smartphones to clothing, according to a Wall Street Journal analysis of trade data released this week by the Census Bureau. China accounted for 13.3% of U.S. goods imports during the first six months of this year, below a peak of 21.6% for all of 2017. The current level is the lowest since 12.1% for the year 2003, two years after China’s accession to the World Trade Organization.
The shift started in 2018 as the Trump administration imposed tariffs on a range of Chinese products. During the pandemic, shortages of products such as face masks and semiconductors prompted companies to rethink their supply chains. This year, some companies cut their reliance on China amid an intensifying bilateral fight over advanced technology. President Biden dialed up the heat Wednesday with an executive order banning U.S. investments in certain Chinese advanced semiconductors and quantum computing. China’s loss of share in U.S. imports isn’t the result of a dramatic change in imports from any one product or country. Instead, slow-moving supply chain shifts across dozens of industries and nations are driving the trend. One factor has been a shift of production to other Asian nations, namely Southeast Asia and India. Starting in early 2019, China’s share of U.S. imports fell below the total share from a basket of 25 other Asian nations including India, Thailand, and Vietnam. That group of nations accounted for 24.6% of U.S. imports in the 12 months ending in June, compared with 14.9% for China, according to census data.
Meanwhile, Mexico’s share of U.S. imports matched China’s in June. The free-trade agreement between the U.S., Mexico, and Canada has made Mexico a strong contender against China and other Asian nations as a supply base to the U.S. A move toward shorter supply chains in the post-Covid era adds to the advantage of Mexico and Canada. Machinery and electronics were among the largest trade categories where Mexico’s share of U.S. imports increased during the year ending in June. When the dollar values of exports and imports are combined, Mexico is now the U.S.’s No. 1 trading partner, followed by Canada, pushing China to third place. The shift reflects a recent decline in the share of U.S. exports to China, combined with a longer-term decline in China’s share of U.S. imports. China accounted for 10.9% of U.S. total trade during the first half of 2023. Mexico tops at 15.7%, with Canada close behind at 15.4%.
3. Mortgage Rates Hit 20 Years High
The average mortgage rate rose to 7.09%, its highest level in more than 20 years, according to data released Thursday by mortgage giant Freddie Mac. The increase extends a lengthy stretch of high borrowing costs that has slowed the housing market to a crawl. This marked the first time since last fall that the rate on a 30-year, fixed-rate mortgage rose above 7%. A year ago, rates were around 5%. The housing market is the part of the economy hit most directly by the Federal Reserve’s high-rate policies. The resulting slowdown in refinancing and purchase activity has battered some mortgage lenders, leading to tens of thousands of layoffs in the industry and weighing on economic growth. Mortgage rates aren’t directly tied to the central bank’s moves. But they tend to move loosely with the 10-year Treasury yield, which on Thursday hit its highest level since 2007. Some analysts see ample room for the 10-year yield to keep climbing as markets brace for the possibility that rates aren’t going to decline soon.
Stocks fell on Thursday, extending August declines, with investors worried anew about continued Fed rate hikes. Fed officials still see inflation risks and the potential need for higher interest rates, according to meeting minutes released this week. When the Fed started lifting interest rates at a rapid clip last year, the rising cost of borrowing to buy a home was expected to be temporary. A year and a half on, rates are climbing back toward their highs, despite briefly dipping toward 6% in late 2022 and early 2023.
Now, buyers, sellers, investors, and real estate players are adjusting to the idea that higher rates are here to stay, or at least here to stay longer than they were expecting. While lots of would-be buyers are struggling to find anything they can afford, plenty of would-be sellers feel stuck in place. Many homeowners are unwilling to put their homes on the market, fearful of giving up low-rate mortgages and being forced to take out loans that are much more expensive. High-rate homeowners who bought recently and were hoping they could soon refinance are coming to grips with the fact that they’ll have to wait a while. Some buyers have given up, deciding to rent for longer than they had planned. But even with fewer interested buyers, a lack of supply keeps pushing prices higher. The buyers that remain are still competing fiercely for the measly stockpile of homes for sale.
4. EU Is Set to Hit Winter Gas-Storage Targets Months Early
The European Union’s gas-storage levels are on the brink of hitting their pre-winter target more than two months early, a boost for the bloc’s economy after energy ties with Russia was all but severed last year following the invasion of Ukraine. The latest numbers mean EU storage facilities could soon fill their capacity of roughly 100 billion cubic meters, covering around 25% to 30% of the gas consumed in the EU during the winter, according to the bloc’s data. However, the energy-security situation in Europe remains fragile and dependent on fluctuations in liquefied natural gas imports, which can be uncertain. In June last year, a few months after the war in Ukraine broke out, the EU established new rules that tasked member states with filling gas-storage facilities to at least 90% of their capacity by Nov. 1 each year, starting in 2023. Concerns about significant energy shortages last winter drove EU member states, especially Germany, to finance a large buildup of energy supplies in 2022. That meant, following a relatively mild winter, the bloc exited the season in 2023 with unusually high stocks. The rapid accumulation of gas has driven down prices, helping Europe avoid the deep recession that many feared last year.
According to the latest data provided by the industry group Gas Infrastructure Europe, the EU’s storage levels were 89.9% as of Tuesday, with 11 of the bloc’s 27 member states over the 90% level and most others close to it. The bloc’s biggest gas consumer is Germany, where storage facilities were 91.6% full. Latvia recorded the lowest percentage of storage filled at 77%. The EU’s gas-storage levels are up from 56% capacity at the end of March 2023. While the EU has prohibited the import of oil and coal from Russia, it didn’t introduce similar sanctions on its gas imports. However, Russia largely shut the EU off from gas supplies starting in the middle of 2022 because of the bloc’s support for Ukraine. To some extent, the ballooning stockpile reflects economic weakness. Industrial demand for gas, which dropped last year when prices rocketed, hasn’t returned, in part because manufacturing activity moved to regions with lower energy bills. The energy supply situation for the EU remains fragile ahead of the new winter, with the war showing no signs of abating. The continent has replaced dependence on Russia’s state-owned energy giant Gazprom with reliance on cargoes of liquefied natural gas imported from the U.S., the Middle East, and elsewhere. So far this year, supplies have flooded into Europe, in part because China’s economic difficulties have curtailed Asian demand.
5. China Steps Up Efforts to Stabilize Markets
Chinese authorities have stepped up efforts in recent days to bolster financial markets in a sign that Beijing is growing uncomfortable with the pace of declines in stocks and the yuan. Mainland exchanges this week asked for some investment funds to avoid net selling equities. Officials requested state-owned banks to escalate intervention to support the yuan, while also encouraging companies listed on the tech-heavy Star Board to buy back shares. The securities regulator said late Friday it will slash handling fees in stock transactions and study extending trading hours for equities and bonds.
The moves complemented the People’s Bank of China’s surprise interest rate cut this week, which was the biggest reduction since 2020, and its most forceful yuan fixing guidance ever on Friday. So far, the measures have yet to buoy the markets. A gauge of Hong Kong-listed Chinese stocks was on course for a third-straight week of losses. The Hang Seng Index is down more than 8% this year, ranking among the biggest global losers. The gauge entered a bear market on Friday. While the yuan eked out marginal gains against the dollar Friday morning, it has fallen more than 5% this year. Rattled by dismal economic data, deflation fears, a weakening housing market, and a crisis in the shadow lending sector, the mainland financial markets are facing the possibility of a vicious cycle of capital outflows. Foreign investors were net sellers of Chinese stocks Friday, capping a record streak of outflows. The announcements on cutting stock handing fees and consideration to extend trading hours “may help smooth out some of the financial market volatility and lower transactional costs, but do not address the core issues of lack of confidence and economic momentum,” said Marvin Chen, a strategist at Bloomberg Intelligence.
6. Rising Oil Prices Are Bad News for Drivers and the Fed
Booming oil prices last year powered U.S. inflation to 40-year highs. That trend was reversing in 2023—until now. Benchmark crude prices are up 21% over the past six weeks, driving up the cost of American workers’ commutes, freight haulers’ trips to and from warehouses, and the production of everything from plastics and fertilizers to clothing. The gains threaten to prop up inflation, just as easing price pressures had investors betting that the Federal Reserve would soon wrap up its campaign of interest-rate increases. Though the central bank’s preferred inflation metric excludes volatile food and energy costs, many warn that rising oil prices will indirectly pull up costs in every corner of the economy.
Diesel’s climb has been particularly costly for JKC during this summer’s heat waves, since the company’s refrigerated semitrailers need to burn more fuel to keep lettuce, melons and other produce cold in transit. The company updates its fuel surcharge for customers once a week, Kucharski said, but prices have risen so quickly in recent days that his company has had to eat some of the costs. Russia’s invasion of Ukraine early last year sent oil prices surging. Prices started coming down last summer after President Biden sent roughly 200 million barrels of U.S. crude reserves into the market and eased further as the Fed’s interest rate hikes helped curtail industrial demand for energy. The more recent run-up comes after Saudi Arabia and Russia cut production to curb supplies to the market. Investor optimism about the strength of the U.S. economy also helped fuel the rise in prices. Over the past three months, wholesale diesel costs jumped 31%, jet fuel climbed 33% and gasoline rose 18%. The surge is challenging investors’ bets that the Fed can pull off a so-called soft landing, in which inflation eases to the central bank’s 2% target without slowing down the economy so much that it tips into a recession. The Fed raised rates again last month, bringing them to a 22-year high. A continued climb in oil prices could signal the economy’s resilience. But too steep of an increase could suggest the Fed will need to keep rates higher for longer. Crude prices will likely buoy overall price pressures heading into the Fed’s next meeting in September when many investors expect a pause in interest-rate increases.
Financial Markets
1. Nasdaq Closes Lower and Treasury Yields Pull Back
Stocks closed Friday’s session with weekly losses, as Wall Street’s August struggles continue. The Dow Jones Industrial Average added about 26 points and was roughly 0.1% higher. The S&P 500 was little changed, and the Nasdaq Composite slipped 0.2%. The Dow ended the week lower by 2.2%, its worst since March. Meanwhile, the S&P 500 registered a third straight week of losses, a streak that hasn’t happened since February. The Nasdaq Composite also fell for a third consecutive losing week, the first since December. Bonds staged a little comeback on Friday. Yields on longer-dated Treasurys retreated after settling at decade-plus highs the previous afternoon. The three major U.S. stock indexes closed mixed but were all down for the week.
Keysight Technologies’ shares lost nearly 14% on the back of a disappointing earnings report. Deere and Estee Lauder also fell about 5.3% and 3.3%, respectively, after announcing their earnings. Shares of major tech companies, including Meta, Amazon, Microsoft, and Alphabet continued their decline for the week. VinFast, the electric-vehicle stock sank more than 15%, for a third day of declines after its eye-popping debut earlier in the week. JD.com, Alibaba, PDD, NIO: The American depositary receipts of these Chinese companies were all down around 3% or more. Investors are parsing a string of disappointing Chinese economic data points, and watching as competition intensifies in certain sectors such as electric vehicles.
2. Second Quarter Earnings Season Summary
As of 08/07/2023, 84% of the companies in the S&P 500 have reported earnings for the second quarter. Of these companies, 79% have reported actual EPS above the mean EPS estimate, which is above the 5-year average of 77% and above the 10-year average of 73%. In aggregate, earnings have exceeded estimates by 7.2%, which is below the 5-year average of 8.4% but above the 10-year average of 6.4%. Companies that have reported positive earnings surprises for Q2 2023 have seen an average price decrease of 0.5% two days before the earnings release through two days after the earnings release. In fact, if this is the final percentage for the quarter, it will mark the largest average negative price reaction to positive EPS surprises reported by S&P 500 companies for a quarter since Q2 2011 (-2.1%).
Why is the market punishing positive EPS surprises? It is likely not due to the earnings outlooks from companies and analysts for the third quarter, which have not been more negative than normal. In terms of earnings guidance from corporations, 62% of the S&P 500 companies (49 out of 79) that have issued EPS guidance for Q3 2023 have issued negative guidance. This percentage is between the 5-year average of 59% and the 10-year average of 64%. In terms of revisions to EPS estimates, industry analysts basically left EPS estimates for Q3 2023 unchanged in aggregate during the month of July. Eight of the eleven sectors are reporting year-over-year earnings growth, led by the Consumer Discretionary and Communication Services sectors. On the other hand, three sectors are reporting a year-over-year decline in earnings: Energy, Materials, and Health Care. Seven sectors are reporting year-over-year growth in revenues, led by the Consumer Discretionary and Financials sectors. On the other hand, four sectors are reporting a year-over-year decline in revenues, led by the Energy and Materials sectors.
3. Stocks’ August Slide Continues as Treasury Yields Touch Multiyear High
Treasury yields continued to climb on Thursday after strong labor market data renewed investor concern about rate hikes. The 10-year Treasury yield rose to 4.307% from 4.258% on Wednesday, settling at its highest closing level since 2007. The 30-year Treasury yield hit a 12-year high, rising to 4.411%. The strength of the U.S. economy and strong inflation expectations have driven up yields. The latest reading: The Labor Department on Thursday reported 239,000 initial jobless claims last week, just below economists’ expectations. Retail giant Walmart said that its sales grew in its latest quarter, with consumers continuing to spend.
Stocks dipped and government-bond yields reached a 15-year high after minutes from the most recent Federal Reserve policy meeting showed central bankers are worried about a possible resurgence in inflation. The S&P 500 fell 0.8%. The Dow Jones Industrial Average dropped about 181 points or 0.5%. The Nasdaq Composite fell 1.1%. All three indexes are down 2.2% or more, so far in August. Recent economic data has lent credence to the notion of a still-strong economy, raising concerns that the Fed’s campaign to raise interest rates may not yet be over. The S&P 500 trades at 18.1 times forward earnings estimates, according to FactSet data. Over the past year, the average valuation for the index is 17.8 times. The broad index is still up 15% this year, despite the August selloff. Some investors say it would be premature to think the rally in stocks is finished altogether. “It’s too early to expect a meaningful shift in market tenor until we see a definitive break in the economic environment,” such as rising unemployment or falling corporate earnings, said Lauren Goodwin, economist and director of portfolio strategy at New York Life Investments.
4. China Developer Evergrande Filed for Bankruptcy
China Evergrande, a behemoth property developer, filed for bankruptcy protection on Thursday more than two years after it defaulted on its debt. The company’s meltdown in 2021 was followed by the defaults of smaller developers and signaled the start of a slow decay of China’s real estate sector that now threatens to inflict damage on the country’s broader economy. Another giant developer, Country Garden, is staring down a default of its own after missing payments to lenders and holding $200 billion in unpaid bills. Evergrande’s bankruptcy petition, filed in the United States bankruptcy court in the Southern District of New York, comes as the company continues to try to settle staggering levels of debt. As of the end of last year, Evergrande reported liabilities totaling $335 billion. The company, which along with affiliates has assets in the United States, is negotiating with its creditors in Hong Kong and the British Virgin Islands. It said in a statement on Friday that it was “pushing forward its offshore debt restructuring as planned” and is seeking the U.S. court’s approval.
That Evergrande is still negotiating with its creditors is a sign of the slow-moving crash facing China’s real estate market. Long the prime avenue for millions of Chinese people to build wealth, the housing sector has in effect seized up because of a turn in government policy several years ago to cool the property market. China’s top leader, Xi Jinping, ordered that homes should be for living, not for speculation. Then, in 2020, the government cracked down on excessive borrowing, limiting the ability of real estate companies to raise money and prompting a series of defaults. The policy change was a sharp comedown for an exuberant housing market that for decades ran parallel to China’s rise as a global economic power but was marred by overbuilding and risky financial practices. Home buyers frequently took out mortgages to purchase apartments before construction was completed, providing developers with a steady stream of revenue they used to operate and build more homes. As the market slowed, consumers were left with debt and no home to show it. Adding to the woes of the housing market, China’s overall economy, the world’s second-largest, is struggling to recover after three years of harsh “zero Covid” measures that left companies wary of hiring, consumers reluctant to spend, stocks suffering and would-be homeowners wary of buying.
5. Hawaii Fires Turn a Safe Investment into a Big Risk
America’s power grid is largely run by private utilities backed by investors seeking slow and steady returns. The deadly wildfire that scorched parts of Hawaii is heightening Wall Street’s fears that the system’s value proposition faces mounting pressure. Investors in recent days have fled Hawaiian Electric Industries, the parent company of a utility by the same name, as victims scrutinize its role in last week’s blaze. A sell-off in the utility’s stock has hammered its share price 68% lower since Aug. 7, a level not seen since 1987, while bondholders have unloaded the company’s debt at steep discounts. Investigators haven’t pinpointed the cause of the fire that killed more than 100 people and reduced much of the oceanside town of Lahaina to ash. But mounting evidence suggests the utility’s equipment was involved. Some survivors have filed lawsuits accusing Hawaiian Electric of negligence, alleging the company heightened the threat in part by running electricity through power lines as high winds swept across Maui.
The fear of massive payouts has led investors to increasingly push for upgrades, such as underground transmission lines, to sometimes aging infrastructure. That spending by utilities across the country, coupled with renewable energy buildouts, ultimately means large bills for ratepayers. “There’s obviously been more and more focus on these infrastructure investments given the weather environment,” said Andrew Bischof, an equity strategist at Morningstar. Hawaiian Electric has been slow to complete such work despite a warning in 2019 that it needed to do more. For now, teams totaling more than 400 people have fanned out across Maui to repair transmission lines and bring electricity back to schools, water facilities, and hotels expected to be used as temporary shelters. The utility said on Thursday that it has restored power to about 80% of customers who lost it last week. Hawaiian Electric Industries, which also owns American Savings Bank, includes three utilities that operate as Hawaiian Electric. The power companies reported a collective $143.6 million cash on hand in June, a sum that analysts say is more than enough to pay for the current cleanup.
6. Applied Materials Expect Tailwinds from China
Applied Materials, a semiconductor maker whose clients include Intel and Taiwan Semiconductor Manufacturing, saw its stock rise Friday, in part on resilient demand in China. That may give hope to the company’s peers as China experiences a bumpy economic slowdown. Applied Materials shares were up 3% in premarket trading after beating estimates on earnings and provided better-than-expected guidance after the bell on Thursday. Broadcom rose 0.3%. Qualcomm was down 0.1%. Semiconductor stocks are in a tug-of-war between forces pulling them in opposite directions. Optimism surrounding artificial intelligence is supporting companies that can capitalize on it. On the other hand, China’s woes and the lingering slump in demand for technology products since the end of the Covid-19 pandemic can pull chip stocks down. Analysts at KeyBanc led by Steve Barger raised their estimates for Applied Materials earnings after the report yesterday but kept their Sector Weight rating on the stock. Shares have already added 41% this year. “AMAT’s strong guidance is a function of its exposure to the more resilient sectors of the semi-cycle including ICAPS (Internet of Things, automotive, power, and sensors) and China, and expected gross margin tailwinds from the latter,” KeyBanc said.
Sources:
(1) www.bloomberg.com
(2) www.factset.com
(3) www.wsj.com
(4) www.nytimes.com
(5) www.barrons.com
(6) www.cnbc.com
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. Economic forecasts set forth may not develop as predicted.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond and bond mutual fund values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.
Investing in stock includes numerous specific risks, including the fluctuation of dividends, loss of principal, and potential illiquidity of the investment in a falling market.
Investing in foreign and emerging market securities involves special additional risks. These risks include but are not limited to currency risk, geopolitical risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.
Investment advice offered through Private Advisor Group, a registered investment advisor and separate entity from The Legacy Foundation.
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