No margin compression, no ’23 recession

Good morning. Over the past several months, we have asked the question: why should investors do anything but sit on short Treasuries at 4 per cent or more? The market has taken note. The two-year yield hit its lowest point in more than half a year yesterday. Bank of America is reporting big client outflows from stocks. The essence of this cycle: the new hot investment has gone from dog-based cryptocurrencies to short-duration Treasuries in less than two years.

In other news, Rob and Ethan will be taking an Easter break beginning Good Friday. The two of us will be back in your inboxes on April 17. But fear not. Our talented markets colleagues, RBA antagonist Jennifer Hughes and Treasury market whizz Kate Duguid, will be filling in intermittently next week. In the meantime, you can email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Margins revisited

Unhedged’s friend Albert Edwards, Société Générale’s famously bearish strategist, published a note on profit margins this week that got us thinking. His primary observation is that, looking at the US national accounts data, it is clear that US corporations have increased prices far beyond simply passing on higher labour and materials costs. His chart:

We already knew this to be true, but it is interesting that the phenomenon persisted through last year’s fourth quarter. As Edwards points out, if you looked only at reported corporate earnings for the S&P 500, you would think that “greedflation” (his term for companies taking what they can) was starting to taper off. S&P operating margins, while still high, peaked at the end of 2021 and have been falling by fits and starts since:

The divergence of national profits (still right near peaks) and public company profits (clearly falling) is important because the national data is better quality than the company data. It includes more companies and is cleaned to remove accounting anomalies. And if profit margins are barely falling, as the national accounts suggest, this has important implications for where we are in the business cycle. Companies respond to margin compression by firing people. In that sense, falling profitability contributes directly to, and is therefore a leading indicator of, recessions.

The national data is not particularly timely, going only through the fourth quarter of last year. But all the same it suggests that worries about imminent recession may be over-egged. As Ethan pointed out yesterday, if you want to make a case for recession, you have no choice but to look beyond what is happening to what might happen next.

Edwards thinks current levels of greedflation are “unprecedented”; I wouldn’t put it that way. Companies are always as greedy as they can get away with — they promise their owners as much. The question is why they can get away with so much right now, even a full year into a steep rate-increase cycle. Or, to look at it from the other side of the market, why are consumers still willing to pay up — and when will they stop?

Part of the answer has to do with coronavirus pandemic-era fiscal largesse, and the resulting excess savings held by US households. Gavekal’s Yibei Dong recently cautioned that the savings won’t provide much more support:

First, households have already drawn down a good deal of the “excess” savings they accumulated. This is reflected by an increase in the personal savings rate since June 2022 — an increase which continued in February. Second, much of the excess in savings, especially among lower-income households, was funnelled into home purchases. The illiquidity of housing and the unusually high opportunity costs of selling homes acquired a year or two ago with low-rate mortgages makes it unlikely these savings will be spent. As payrolls growth slows, this suggests US consumption growth is likely to weaken. Investors should underweight consumer discretionary stocks.

We tend to agree with this sentiment, but are cautious about using the excess savings data from the US Bureau of Economic Analysis, for reasons explained to us by Skanda Amarnath of Employ America. The savings data is a mathematical residual of other aggregate data sets (personal income, outlays and taxes) that can vary for reasons that render the residual figure unreliable. Better, Skanda says, to simply look at what wages and consumption are doing. And when we look at that, what we see is that while earnings and spending are decelerating, they are still growing fast in nominal terms, and in aggregate — that is, in terms of total amounts earned and spent — and outpacing inflation:

One needs to keep this in mind when looking at more timely data that shows retail spending coming off. Citigroup’s Paul Lejuez publishes a monthly report showing retail spending trends among Citi’s US credit card customers. It shows spending declining quickly on a year-over-year basis:

Remember, however, that retail spending on Citi cards is (as of this week) still 20 per cent higher than it was pre-pandemic 2019. Again: consumers’ outlays are falling, but only from a very high level.

Economic change does not happen smoothly, and given the rapid increase in rates, it makes sense to think that some rapid-fire conflagration might hit consumers’ willingness to spend and therefore corporate margins. But at the same time, we have to look at what the data is saying right now. And what it’s saying is companies have pricing power, margins are high and recession is not imminent.

Two more points on EM allocations

On Monday we wrote about the longer-term case for emerging market equities, which, in boiled-down form, is that valuations are extremely low while fundamental risks have receded.

That piece drew on a paper by Michele Aghassi and Dan Villalon of AQR, which has one important point we didn’t get to on Monday. By plain old valuation measures (like a forward p/e of 12), EM stocks look cheap, but Aghassi and Villalon have done more detailed work on just how cheap. They look at EM value spreads, an AQR-popularised measure that tracks the dispersion in multiples between the cheapest and most expensive stocks within each industry. Like US stocks, the cheapest stuff is really cheap:

We asked Aghassi yesterday whether any particular country or sector value spreads stood out but, to our surprise, she said:

When we looked at this more granularly in a variety of ways — whether it’s different countries, different sectors, or large-cap versus small-cap — what we’ve tended to see is that it’s quite pervasive. It’s not isolated to any one corner of the [EM] universe . . . 

We think these value spreads represent a mispricing that isn’t justified by the fundamentals.

Still, one area where some investors think cheapness is indeed justified by the fundamentals is in China. This was the view of Jitania Kandhari, a longtime EM portfolio manager at Morgan Stanley Investment Management. Like Aghassi, she is broadly bullish on EMs, arguing many have spent the past decade staging a “clean-up act”, paring back debt and shrinking current-account deficits. But she says China is different:

At the end of the day, China is 32 per cent of the MSCI emerging markets index, and [its most promising sectors like EVs and solar are] not a very big share of the index. And remember: China is over-indebted, it is definitely going through geopolitical issues, it has a depopulation headwind . . . so China has selective opportunities, but it’s not had that clean-up act. Debt is still in the system, and policymakers play a whack-a-mole game from one segment to the other. That’s going to keep weighing on productivity and growth.

Kandhari adds that many of the Chinese stocks a passive EM investor would hold are “winners of the last decade”, such as consumer technology, which could lag if (as she suspects) market leadership shifts to more exciting names in green tech.

Given attractive valuations elsewhere, and especially in other EMs, why bother with China risks?

One good read

Here’s a tidy slogan for the current stage of the business cycle: “What initially seemed like access to free money became a liability”.