Andrew Pyle
August 04, 2023
Too many people on one side of the boat again
Before launching into this week’s commentary, I would be amiss to not wish my daughter Georgy a happy and wonderful 28th birthday. She came into this world the day my partner and I had started PATH International – a company that was to be another entry into the industry of real-time market analytics (the two of us coming from the first of its kind in this sector – MMS International). 1995 was also the year that Yahoo was incorporated and we were just getting our teeth sunk into this thing called the internet. In fact, in the early days of MMS, we would type our analysis and commentaries of global events live on Telerate, Reuters, Bloomberg and Knight Ridder terminals. How much easier it became to write once and send to multiple streams at once.
It's amazing that less than three decades ago we were not even used to searching on the internet (Google didn’t show up officially until 1998), and yet here we are gleaning through every financial report looking for mention of how a company is going to utilize Artificial Intelligence (AI) in its future operations. This has definitely helped to propel U.S. equity markets to the heights reached this summer, though driven by an extremely narrow segment of the market (the “magnificent seven”). This week, we saw a few nuts come loose on the AI wheels as investors became more demanding of huge beats on quarterly results.
So far this earnings season, more than 80% of S&P500 companies have reported and close to 60% have beat estimates on revenues and 80% have beat on earnings. You might think that most of this came from the tech sector and, for sure, roughly 88% of companies in this group came in above consensus on earnings; however, 92% of consumer staples firms came in better than expected. Incredibly, there has not been one single major segment of the market that has seen less than a 50% beat on earnings. The worst performer has been real estate with “only” 63% of companies beating the street. As much as this sounds great, there are a few problems.
First, when we came into 2023 the consensus was for a North American recession to develop by this summer because of the aggressive monetary policy tightening implemented by the Federal Reserve and Bank of Canada last year. As rate hikes continued in the first half and cost pressures remained, analysts marked down their estimates of where revenues and earnings would come in. In other words, the bar was set lower. This week, we saw the first major U.S. bank revise its economic outlook, switching out its call for a recession for a slowdown instead and it joined a chorus of other major market participants who had collectively jumped off the recession ship for a Goldilocks soft landing.
The above chart shows the Bloomberg consensus 2023 U.S. real GDP growth forecast by week. As you can see, economists were a gloomy lot at the end of last year, predicting less than half a percent in GDP growth in 2023 and that had a mild recession (two consecutive quarters of contraction) baked in. Thanks to two quarters of real data under the hood, showing annualized growth of 2% in Q1 and 2.4% in Q2, the consensus call for the year as a whole has risen to 1.6%. That is higher than the midway mark between the pre-tightening call for this year (2.5%) and the low in December. I don’t believe that consensus will get back to 2.5%, but the trend could prompt an upward revision to corporate revenue and earnings estimates in the next two quarters. The danger in that is that things don’t pan out that way.
The other dilemma for investors is that the street is getting very particular about what boats in this somewhat rising tide look good and which don’t. This past week we saw a number of examples where companies reported results that were slightly above consensus, but they weren’t rewarded for doing so. Similarly, for those companies that reported results that were just under consensus, they were punished. In fact, of the 11 S&P sub-groups that beat on earnings this quarter, only two sectors saw a positive one-day share price increase. The rest were in the red. That tells me that the bull market foundations are beginning to weaken.
Of course, there was more at play this week than just earnings. We had Fitch remove the triple-A rating on U.S. government bonds at the same time that the former President of the U.S. was indited for a third time. And, yes, the U.S. treasury announced that it would be increasing its issuance of long-dated bonds in an environment where inflation remains stickily high. This sent the 30yr treasury bond yield up through 4.2% for the first time since last November. Now, part of this is intuitive given that the Federal Reserve has lifted rates 1-1/2% since November so all yields should be up and even above where they were back then. Fair, but remember that the rate hikes from last year and this year were going to cool the economy and inflation, leading to lower inflation expectations and lower long-term bond yields.
It’s amazing what happens when folks throw in the towel on recession calls at the same time there is a wake-up call on the fact that the U.S. has a potential fiscal train wreck on its hands. The move higher in bond yields isn’t something that we are particularly worried about though. It will present additional borrowing woes for companies, households and governments around the world, but this only adds a drag to economies and most likely puts them on a trajectory that is now beneath the consensus view.
This past Wednesday, I appeared on BNN Bloomberg with Amber Kanwar and one of the topics we dealt with was valuations and how recent shifts in the bond market could influence investor behaviour. At the core, there is an ongoing decision by investors between how much risk to take in a portfolio relative to return. Back in the days when policy rates were not far from zero and bond yields were maybe a few percentage points higher, relative value decisions between risk capital (stocks) and fixed income (bonds) were hard – even in periods with storm clouds. The decision is a lot easier today.
When examining the relative value between stocks and bonds we will often look at the difference between what a bond provides us in terms of yield versus the dividend yield on a stock. The dividend yield is just the dollar amounts of dividends you receive for owning a stock divided by the market price of that stock. If we expand this to an index, like the S&P500, then we are looking at the total dividend payout from companies in the index relative to the market value of the S&P. The above chart shows the spread between the 30yr U.S. treasury bond yield and the dividend yield of the S&P. On Thursday, this spread crossed above 270 basis points (2.7%), even though at the time of my interview on BNN it was still below the peak seen last October. Now that we are through that high, the spread is at the highest since 2010 and 2011 when we got close to 300 basis points.
When I was on the show we talked about last October when this spread was 260 basis points and why the stock market didn’t collapse. For me, the answer was simple. There was little room for relative value back then. The S&P had just dropped 25% from the start of the year and the aggregate U.S. bond index was down 17%. Why sell stocks when they had just dropped more than bonds, despite the yield spread? Today, the S&P is up more than 25% versus a 2.4% gain in the aggregate bond index. Hence, there might just be a little more motivation to trim back on equities and shift into bonds to take advantage of that yield differential.
This doesn’t mean that stocks are about to drop sharply. There is a significant amount of momentum that still exists in this market and it will take more than a few negative economic surprises to cause people to shift back over from the soft-landing side of the ship to recession. Ally and I have been calling for a recession to emerge by the early months of 2024 and we adhere to that view, especially if upcoming economic data supports a trajectory for policy rates that is higher than currently expected. The main lesson from these past couple of weeks is that you have to be careful when most people on the boat start to shuffle to one side.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle, Senior Portfolio Manager, Senior Wealth Advisor
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