As July approaches, let’s read the market tea leaves for 2H2022 and beyond. Over the past few weeks, markets have priced a broader growth scare as commodity equities sold off sharply and Treasuries priced a lower and earlier peak in Fed Funds rate. However, bonds markets were blind to the inflation surge, so why should we trust the market’s latest view on growth? To us, the growth vs inflation pendulum remains murky as the Fed is forced to hike rates into a recession. While client portfolios have benefited from a cautious 1H22 stance, The Dispatch is focused on the following issues as we gaze out to 2H22 and beyond.
- Asset markets are pricing a slowdown, but is it accurate?
- Are earnings about to disappoint?
- Valuation: trailing and forward earnings look attractive, but CAPE remains poor.
- Inflation: Headline down, but core sticky
In crypto asset, liquidation of troubled entities remains unresolved. Depositor funds remain frozen at Celsius, and Three Arrows Capital (3AC) could be winding down. Will the capital injections into BlockFi and Voyager stem liquidations? There are plenty of unanswered questions that leads to an opaque and uncertain near-term outlook. With global liquidity shrinking, we maintain a cautious approach even as technical indicators point to attractive long-term entry points. Volatility is a feature of the emerging crypto asset class. Keep positions size small and investment horizon long.
Dispatch #15 on June 30th, 2022, has the following line up of stories:
- Market tea leaves for 2H22 and beyond
- Crypto Asset outlook remain uncertain
- FTX & SBF become the Berkshire & Buffet of crypto
- M&A spikes in NFT marketplaces
Market tea leaves for 2H22 and beyond
There’s really no doubt of a slowdown
Last week’s sell-off in commodities, ebbing Atlanta Fed GDPNow forecast and high frequency transport data all point to slowing activity. The Fed should be happy to see this data as it needs cooling economic activity to ease inflation.
Here is the Atlanta Fed’s 2Q GDPNow forecast, which dropped sharply to -1.0% growth in 2Q. In the meantime, the Wall Street herd is huddled around 3% growth.
With deteriorating data, it should be no surprise that Fed Funds futures started pricing a lower and earlier peak in rates. This is how rates react in typical recessions. However, what if core inflation remains high despite slowing growth? As we’ve highlighted many times since publishing our inflation view in July 2021’s Dispatch #23, shelter makes up ~42% of the core CPI basket, and this will continue to rise as rents catch up with the home price surge.
In that scenario, lower market yields result in prematurely easing financial conditions even as the Fed’s goal is tighter financial conditions. It’s possible, then, that the Fed is forced to tighten further to offset the lower market rates. Financial markets are not positioned for this unusual scenario. Consequently, we’d like to keep some powder dry for several more months until we can be more confident of the economic path.
Elevated bond volatility means rapid shift in the yield curve
Don’t take the above change in yield curve as set in stone because bond volatility is elevated, as the chart below of the MOVE index (this is the VIX for bonds) shows. The rate outlook could change swiftly as it has all this year. Furthermore, bond markets have proven inept at predicting inflation and growth this year. Just like Wall Street stock analysts waiting for companies to provide guidance, bond traders appear to wait for the Fed minutes to price bonds.
Other signs of markets aggressively pricing a recession include the S&P500 materials sector losing 1.5 years of performance in one month! Commodities demand is more sensitive to economic activity than many consumer items.
Inventory spike could lead to deeper recession
Most recessions are brought on by production falling due to excess inventory. In this current cycle, we supercharged GDP by handing out stimulus checks that sharply raised goods consumption by stuck-at-home consumers. The initial Covid stoppage added to excess ordering as supply chains struggled with the stop-start and followed by demand surge. This tweet by CEO of Simple Modern provides an excellent explanation of why most retailers and brands are stuck with excess inventory today. A few of the tweets are below. We recommend reading the entire thread to understand the wider impact.
These effects are already plainly visible in the economy. Bed Bath & Beyond has slashed prices to clear excess inventory, disclosed a wider loss and fired the CEO. The stock, which was a meme darling, is down more than 80% from the peak. The excess inventory and slowing orders are visible in trucking volumes that continue to decline. Craig Fuller of Freight Alley is a good Twitter follow for this data.
Earnings are disconnected
Despite all of the evidence of a rapidly decelerating economy, Wall Street earnings projections remain steady as shown below.
Earnings projections are holding steady despite many predictive metrics pointing to risks of earnings downside. The following charts highlight some trends.
Source: Crescat Capital
The 2Q earnings that start in July should provide a better gauge to the direction of earnings. We see risks to the downside. The section below puts earnings alongside valuations.
Valuations: Attractive on short-term measures, but expensive on longer-term earnings
Much of the valuation discussion revolves around forward earnings (next 12 months – NTM) or the trailing earnings (last 12 months – LTM). With the economic boost of 2021 and near record-high margins, there’s no surprise that earnings based on NTM & LTM look attractive. See chart below.
Source: Jurrien Timmer
A combination of lower stock prices and historic high margins/profits makes LTM and NTM valuations look attractive. There’s a fierce debate if margins will mean revert or if margins are likely to remain structurally higher. This is a complicated subject that The Dispatch will tackle at another time. Our current thinking is that margins do come down in the short term (1-2 years), but are likely to remain elevated from a longer historical perspective. That’s because of higher consolidation within industries and the unlimited lobby clout of corporates after the Supreme Court’s Citizen’s United decisions in 2010.
However, the longer-term outlook is poor as this CAPE chart illustrates. The 10-year CAPE ratio has been an accurate predictor of returns over the next decade. It is NOT a tool for short-term investing. The purple line shows the very low annualized return prediction for the next decade at current prices.
Another ratio that remains elevated is the the Buffett Indicator (market cap to GDP ratio). The long-term trend line in the chart, continues to rise as a higher ratio of US companies today obtain profits from overseas. Market cap includes the value of overseas sales/profits whereas, as a net importer, US GDP does not.
Source: Current Market Valuation
At best, valuation offers an inconclusive signal, and at worst, there’s material downside to trend levels as both earnings and valuation derate.
Inflation: Headline to drop, but core remains stubborn
Much of the macro outlook hinges on the inflation outlook. If inflation eases rapidly, the Fed will have a better chance of not tipping the economy into a deep recession due to rapidly rising rates. There’s good news in June as easing commodity prices should bring headline inflation lower. This assumes the commodity price trends persist. BCOM in the chart below is the Bloomberg Commodity Index
Source: Jurrien Timmer
As we have reiterated many times, core inflation is likely to remain sticky because of the lagged effects of house prices. The chart below shows how a far large portion of US inflation is coming from stickier service prices.
House prices feed through via shelter, which is 42% of the core inflation basket. It is a smaller percentage in the Fed’s preferred core PCE metric, which has a much higher weight for healthcare. We anticipate healthcare costs starting to rise now that the economy is fully reopened, and consumers return to normal healthcare consumption. Hardly anyone is talking about the potential for healthcare cost to take over the inflation baton from shelter come 2023.
Crypto assets – the uncertainty remains
The recent stress events in crypto highlighted in Dispatch #14 have not been resolved. Three Arrows Capital (3AC) the biggest source of stress appears to be headed to liquidation. This means some of their position unwinds could be in the future. There are serious allegations, coming from crypto insiders, of wrongdoing by 3AC. You can hear those allegations starting at ~ 11m50sec point of this On The Brink podcast by Nic Carter and Matt Walsh of Castle Island Ventures.
There’s been no news out of Celsius, with customers fund still frozen. BlockFI and Voyager appear closed to obtaining funds from crypto exchange FTX (see next story). Babel has put a $1,500 per month limit on withdrawals according to Coindesk. All these issues need to be cleaned out before we can assume the recent stress is behind us. And, a resolution does not change the outlook for additional pressure as liquidity continues to shrink and traditional markets selloff, along with the economy.
FTX & SBF become the Berkshire & buffet of crypto markets
Sam Bankman-Fried (SBF), the Founder of crypto exchange FTX has become the Warren Buffet of the crypto world by providing lines of credit to embattled crypto lenders. Many of these firms have encountered trouble due to Three Arrows Capital (3AC) defaulting. FTX has announced $250m funding agreement with BlockFi and an additional deal with Voyager. The initial reporting was of FTX/SBF providing lines of credit, which sounded too generous.
We have since heard that the “revolving credit facility” would wipe out existing shareholders of BlockFi, which include a long list of venture firms. And the latest appears to be a sale to FTX for $25m. BlockFi raised money at a $3.5bn valuation in 2021.
This is how capitalism is supposed to work. The company overextended itself and the repercussions are being felt by shareholders. There is no socializing of losses by taxpayers, which has been the operating norm in the traditional world. Socializing losses first started with the unwind of hedge fund Long Term Capital and was super charged during the GFC and Covid crisis.
A second take away should be the poor business practices and risk control at these firms. Voyager, the listed Canadian company disclosed a uncollateralized $660m loan to 3AC, which is in default. This Fortune article provides more details on Voyager’s exposure to 3AC. Voyager shares have dropped from a peak of C$24.0 to 72c this week.
NFTs are gaining legitimacy as Gucci, Paypal and Uniswap acquire NFT platforms
Three NFT marketplaces were snapped up by well-known traditional companies and a digital asset firms this week. Global luxury brand Gucci invested $25K in LooksRare Dao (token ticker: RARE), an NFT marketplace.
Gucci has an ongoing relationship with SuperRare, as Gucci’s Twitter feed shows. This investment is one of Gucci’s many Web3 initiatives according to The Block.Uniswap, the dominant decentralized crypto exchange, acquired NFT market place aggregator Geniexyz as explain in this Tweet thread. Finally, Paypal purchased NFT marketplace KnownOrigin as this Decrypt article explains.
The Dispatch has been skeptical that many JPEG NFTs (aka PFPs or profile picture) projects could sustain high prices. Those prices have cooled along with the broader crypto asset prices. However, these actions by mainstream and blue chip Defi companies are hard to ignore. Boomers and GenXers might not get it, but the younger generation continues to spend more time online, and digital culture will grow more important. Could the crypto winter provide attractive entry points to the future gateways of digital culture and value? We’ll be doing work in this area.
Happy fourth of July to everyone celebrating. Stay safe and do reach out if you have any questions or comments about the material in this Dispatch.
Asi
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