Risk on, economy off

Good morning. Most of the big earnings reports yesterday, most importantly Microsoft’s, were just fine. Deep breaths. Tesla this afternoon; Visa and Mastercard tomorrow. Everyone feeling good? Email us: robert.armstrong@ft.com & ethan.wu@ft.com.

Risky risk on

Here’s an updated version of one of our go-to charts, sector performance within the S&P 500:

The most defensive sectors — utilities, healthcare, consumer staples — are the bottom of the league table so far this year. What is more, in the sectors that have done well, it is most risky, volatile and previously beat-up subsectors and companies that are leading the way.

In the communications sector, the video entertainment companies (Warner Bros Discovery, Paramount, Disney, Netflix et al) explain the bulk of the outperformance. Meanwhile, they are still in the midst of a content-spending knife fight. In consumer discretionary, the leaders are travel and casino companies. Super-cyclicals such as chips, chemicals and steel are carrying the tech and materials sectors. Airlines and homebuilders are screaming. It goes on and on.

Dec Mullarkey of SLC Management sums up neatly: “The market has concluded that we have seen the worst.”

This conclusion is absolutely consistent with the view that inflation is falling quickly and the US Federal Reserve will be cutting rates by the end of the year. Many of the cyclical industries just mentioned are leveraged, rate sensitive or both.

What it is not consistent with is recent news about the economy, which clearly signals a slowdown that would meaningfully depress earnings of cyclical companies. Recall that:

• ISM services new orders index fell by 10 percentage points in December to a contractionary 45.

• The Empire State manufacturing survey plunged in January.

• The Conference Board leading indicator index (which is a coincident indicator, but never mind) fell 1 per cent in December and is now at levels last hit at the start of the coronavirus pandemic and, before that, during the great financial crisis.

• Retail sales fell by 1.1 per cent in December.

• The 3-month/10-year yield curve remains very much inverted.

• Etc etc, ad nauseam.

Yes, lower energy prices and milder weather have helped Europe avoid the worst and China’s Covid reopening may provide a demand boost. In the US, though, the economy is slowing rapidly and unambiguously.

The economy was looking quite resilient until late in the fourth quarter, but some intimations of trouble ahead have been discernible in early earnings reports. Manufacturer 3M, which sells a huge range of products to consumers and industry, expects unit volumes down in the mid single digits in the year ahead:

Slower-than-expected growth was due to rapid declines in consumer-facing markets such as consumer electronics and retail, a dynamic that accelerated in December as consumers sharply cut discretionary spending and retailers adjusted inventory levels. We also saw a significant slowing in China due to COVID-related disruptions, along with moderating demand across industrial markets . . . we expect the demand trends that we saw in December to extend through the first half of 2023

While we would think reports such as this will be uncommon during this reporting season, by mid-year they could be standard fare. Don Rissmiller of Strategas writes:

We continue to expect market participants to shift their attention away from price inflation (already peaking) and to the possibility of recession as we move into 2023 (consistent with the still-inverted US yield curve, weak regional Fed surveys through Jan, and the Conf. Board leading indicator).

When and if such a shift in attention comes, market leadership could shift back to defensives again.

DoJ vs Alphabet 

The US justice department sued Google yesterday, alleging the company is a monopolist that has the digital ad markets in a stranglehold.

As it happens, I got my start in journalism writing about this Google antitrust story at Adweek, the Madison Avenue trade magazine. Back then, I spoke with a lawyer close to the case, who drew an analogy with financial markets. Google, the lawyer said, had huge influence over ad buyers, ad sellers and ad exchanges. Switch the word “ad” to “stock” and the conflicts of interest, and need for regulation, become obvious.

A few years later, here is the DoJ’s lawsuit:

Google, a single company with pervasive conflicts of interest, now controls: (1) the technology used by nearly every major website publisher to offer advertising space for sale; (2) the leading tools used by advertisers to buy that advertising space; and (3) the largest ad exchange that matches publishers with advertisers each time that ad space is sold. Google’s pervasive power over the entire ad tech industry has been questioned by its own digital advertising executives, at least one of whom aptly begged the question: “[I]s there a deeper issue with us owning the platform, the exchange, and a huge network? The analogy would be if Goldman or Citibank owned the NYSE.”

The finance analogy may understate the problem. Digital ads, though they trade in high-volume computerised markets similar to stocks, have distinct buyers (think luxury watch brand) and sellers (think FT.com), unlike in the stock market, where many participants both buy and sell. Because ad buyers and sellers are distinct, each side requires its own unique services. Buyside and sellside platforms tend not to overlap, but there are exceptions. The biggest by far is Google, which owns important services on both ends (blue and green below), as well as the biggest digital ad exchange (yellow). A helpful graphic from the lawsuit:

The suit goes on to detail Google’s alleged anti-competitive conduct, such as using its ad network to steer advertisers on to the company’s own exchange. One scheme, codenamed Project Bernanke (so called because it “resembled quantitative easing” for ads), involved Google using its visibility into the ad market to surgically subsidise competitive ad auctions while upcharging advertisers for uncompetitive ones. Google’s cut grew, but its customers had no idea, the DoJ alleges.

At a high level, Google’s net income margins do look extraordinarily wide and stable against the volatile ad tech industry:

Google, in its defence, emphasises the company’s formidable competitors. As ecommerce and streaming ads grow relative to traditional display ads, Amazon and TikTok are eating up larger and larger shares of ad spending, and specialised ad tech rivals such as The Trade Desk have been able to peel away market share from Google. Apple’s iPhone-focused ad business is also growing fast.

These sorts of cases are highly complex and take years to resolve, so it is with real trepidation that we offer an early impression.

Google’s market power is hard to deny and, to its credit, the government has specific, documented instances of it using that power to edge out competitors. In that sense the suit appears to have teeth, and Google has nodded to this by offering pre-emptive concessions. But the last milestone tech antitrust case is instructive: in 2001 the DoJ opted to settle with Microsoft rather than fight to the bitter end. The settlement, which imposed a number of technical restrictions on Microsoft, has clearly not dented its ability to turn a profit in the long run.

And remember, Google’s big cash cow is not display ads, but search (72 per cent of ad revenue), which is implicated by a separate lawsuit launched in 2020. In that case, the government is advancing a weaker argument that Google’s search-exclusivity deals are an antitrust violation. The threat to Google’s profits is not zero, but it seems small. (Ethan Wu)

One good read

Call Jeremy Grantham a permabear all you like: he’s been right about this cycle so far (as he has been in more than one earlier cycle). He has some thoughts about where we go next. They are not cheerful.