Weekly Research Briefing: Grab a Chair

@NickTimiraos: The Fed's preferred inflation gauge, the personal-consumption-expenditures price index, fell to 3% in June from a year earlier. It was the lowest 12-month print since March 2021. 3-month annualized rate: 2.5%.

6-month annualized rate: 3.3%.

@bespokeinvest: US GDP Price Index falls to 2.2% in Q2 2023 after hitting 9% in Q2 2022.

@KathyJones: Employment Cost Index (ECI) up 1.0% vs 1.2% in Q1, slightly below expectations. Core pce up 0.2% for 4.1% yr/yr slowing from 4.6% last month. Heading pce up 0.3% for yr/yr rate of 3.0%. Personal income up 0.3% and spending up 0.5%.

"Lower commodity prices have catalyzed a collapse in the wholesale price of electricity, and consumer electricity prices have begun to reverse their 25% increase since 2019"... "the tailwind from cheaper electricity could offset as much as half of the consumption drag from the resumption of student loan payments."

"Between now and the September meeting we get two more job reports, two more CPI reports. I think we have an ECI report coming later this week, which is the employment compensation index, and lots of data on economic activity. All of that information is going to inform our decision as we go into that meeting. I would say it is certainly possible that we would raise funds again at the September meeting if the data warranted and I would also say it’s possible that we would choose to hold steady at that meeting."

“The real federal funds rate is now in meaningfully positive territory. If you take the nominal federal funds rate, subtract a mainstream estimate of near-term inflation expectations, you get a real federal funds rate that is well above most estimates of the longer-term neutral rate. So I would say monetary policy is restrictive, more so after today’s decision, meaning that it is putting downward pressure on economic activity and inflation. We’ll keep monetary policy restrictive until we think it’s not appropriate to do so.”

- Fed Chair Jerome Powell

On Wednesday, Fed Chair Jerome Powell said a soft landing has long been his base case, and his confidence in it had grown. “We’ve seen so far the beginnings of disinflation without any real costs in the labor market,” he told reporters after the Fed’s policy meeting. “That’s a really good thing.”

Powell also disclosed that the Fed staff, which earlier this year projected a recession, no longer does. The staff forecast doesn’t necessarily reflect policy makers’ own views.

The second-quarter report on gross domestic product also helped the case for a soft landing. The 2.4% growth rate was faster than the economy’s long-run trend, mostly thanks to business investment. Consumer spending grew a relatively subdued 1.6%. Inflation excluding food and energy, by the Fed’s preferred measure, was lower than economists expected, at 3.8% annualized for the quarter. Though still far above the Fed’s 2% target, that was still the lowest in over two years.

I asked Summers about all the predictions that unemployment would have to spike to get inflation down.

He said: “I think it's fair to say - given how hot the economy is - the inflation performance at this point is better than I think many standard models would have predicted..."

U.S. Economic Growth Accelerates, Defying Slowdown Expectations

Faster economic growth this spring raises the prospect of a longer post-pandemic expansion despite the Federal Reserve pushing interest rates to a two-decade high. Gross domestic product grew at a seasonally- and inflation-adjusted 2.4% annual rate in the second quarter, the Commerce Department said. That was faster than economists expected and above the 2% growth in the first three months of the year, Sarah Chaney Cambon and Christian Robles report.

Consumer spending cooled but rose enough to drive overall growth alongside much stronger business investment in the second quarter. Those factors combined to buck economists’ earlier expectations that a downturn would start in the middle of this year due to higher interest rates. Solid growth adds to the prospect of a soft landing—in which inflation returns close to the Federal Reserve’s 2% target without a recession.

@WhiteHouseCEA: Nonresidential private fixed investment accelerated, contributing 1 percentage point to Q2 growth. Private construction of manufacturing facilities alone, such as factories, contributed about 0.4 percentage point, this category’s largest growth contribution since 1981.

With both lower inflation risk and lower recession risk now squarely part of the market discussion, it is harder to see what can really provide a further upside surprise in the second half of the year. one candidate is the global industrial cycle, with manufacturing surveys and output measures easily the weakest part of the global activity data set ... in the US manufacturing sector, industrial rail volumes, container exports, and steel production have all rebounded by a few percent since the spring, and the large declines in housing activity seem mostly behind us. these are only scattered indications, but relative to the mostly consensus and mostly correct view of weak industrial activity, they could pose an important upside risk in H2 2023.

@RenMacLLC: In July's Chicago PMI, new orders improved to a three month high (admittedly only to 43.0) while the inventories sub-index plunged to 34.2, the lowest since the pandemic. This is not sustainable and implies that stronger production growth is on the horizon.

Latest estimate: 3.5 percent -- July 28, 2023

The initial GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2023 is 3.5 percent on July 28. The initial estimate of second-quarter real GDP growth released by the US Bureau of Economic Analysis on July 27 was 2.4 percent, equal to the final GDPNow model nowcast released on July 26 after rounding.

@bespokeinvest: Home prices in Cleveland, Chicago, Detroit, New York, and Atlanta made new all-time highs in May (the latest data from Case Shiller). Midwest on FIRE.

Americans locked in ultralow rates on debt such as mortgages and auto loans in the decade-plus that followed the 2008 financial crisis. Though rates on some loans such as credit cards are rising with the Fed’s hikes, a huge chunk of consumer debt carries the low yields on offer a few years ago. That has allowed many households to continue spending, which has kept the economy going strong despite predictions of a recession. The U.S. economy grew 2.4% in the second quarter, the Commerce Department said on Thursday.

As of the first quarter, only 11% of outstanding household debt carried rates that fluctuated with benchmark interest rates, according to Moody’s Analytics. That metric has hovered around this historically low level for over a decade. But it only started to matter when the Fed began its campaign.

Fixed-rate debt became more common after the 2008 crisis, when lenders turned away from products such as adjustable-rate mortgages and home-equity lines of credit that played a role in the bust. Households have also spent the past decade-plus loading up on auto and student loans, which typically carry fixed rates...

Gary Marsh, 66, paid cash to build his Sonoma County, Calif., home in 2020 and the following year took out a 2.75% mortgage on the property that provided him with a lump sum of about $300,000. He recently put those funds into certificates of deposit at local banks paying about 4.75%.

“The low mortgage rate has allowed me to work less, travel more and mostly to feel more free than I ever have,” said Marsh, a writer for real-estate companies.

@bespokeinvest: After topping 12 a year ago, the Misery Index that sums the unemployment rate with YoY CPI is back in the 6s. Consumers appear to have taken notice.

With inflation still soaring and corporate profits looking shaky, business leaders were hardly a confident bunch in the first half of the year.

Today, the outlook is rosier, chief executives increasingly say. And that optimism is reflected in a phrase that has become one of their favorites: “soft landing.”

Executives at S&P 500 firms have uttered the words with more frequency on earnings calls, suggesting a growing belief that the economy is likely to avoid a recession.

Chris Nassetta, the chief executive of Hilton, used those words on Thursday to tell investors that the boom in travel spending was likely to tail off after this summer, but that he was still feeling upbeat about the strength of the consumer.

“The consensus view right now, broadly, is that it’s going to slow down, but it’s more of a soft landing,” he said. “We have reasonable sightlines now into the third quarter, which we feel very good about.”

David Solomon, Goldman Sachs’s chief executive, saw reason for optimism back in February when he said the economy was probably headed for “a softer landing.” That call is looking prescient after this week’s surprisingly strong G.D.P. reading.

If there’s an explanation, it’s the opportunity presented to corporate treasurers by central banks’ decision to leave rates at zero throughout 2021, now almost universally panned as a mistake that contributed to inflation. But at least it helped indebted companies lock in low rates. That makes them impervious to subsequent raises in policy rates — or at least lengthens the monetary policy “lag” to the point when their fixed deals run out.

The effect is spectacular. Albert Edwards, veteran investment strategist at Societe Generale SA, describes the following chart as the maddest he has ever seen. That’s quite an accolade.

Net interest payments by companies should rise as rates rise, all else equal. And even if the relationship isn’t one for one, they surely cannot make a significant fall just as the interest rate on those payments goes through a sharp rise. But that’s what happened.

Treasurers had time to arrange long-term fixed finance, and pay off old higher rate loans, so that they are now paying much less in interest than when fed funds was pegged at zero. Not only that, but the inverted yield curve makes it profitable to lend to banks (by putting money into deposits) over longer terms. Edwards’s conclusion, therefore, is:

A sizeable proportion of huge, fixed rate borrowings during 2020/21 still survives on company balance sheets in variable rate deposits. Companies have effectively played the yield curve in reverse and become net beneficiaries of higher rates, adding 5% to profits over the last year instead of deducting 10%+ from profits as usual. Hence it’s not just ‘Greedflation’ that has boosted US profit margins and delayed the recession. Interest rates simply aren’t working as they once did.

[GE] CEO: Have not seen ANY signs of demand softening in the face interest rate hikes; We see some inflationary pressure abate - post earnings comments

BA plans to ramp up production of 737 MAX narrow-body jets to 38 from 31 per month, indicating recovery in supply chain.

SHW (+). The paint company reported a large beat and raise, driven by better-than-expected sales volumes, and delivered more optimistic 2H23 commentary."

[PHM] Reports Q2 $3.21 v $2.47e, Rev $4.19B v $3.96Be

• Net new home orders 7.95K, +25% y/y
• Closings 7.5K, +5% y/y
• Avg selling price $540K v $524K y/y (+3%)
• Adj Gross margin 29.6% v 30.9% y/y (Non-GAAP)

CEO: "While there remains an extremely limited supply of existing homes, we have an expanded community count and a much improved supply chain that has PulteGroup well positioned to meet buyer demand going forward."

SCHW (+). The online broker reported strong net interest margins and ended the quarter on a high note, with +5% organic growth of client assets in June -- well above consensus forecasts.

[NOW] "We note revenue growth accelerated by about 100 basis points, which has been elusive within our coverage over the last six quarters."

$GOOG CEO: "With fifteen products that each serve half a billion people, and six that serve over two billion each, we have so many opportunities to deliver on our mission"

@charliebilello: The $VIX ended the day at 13.33, its lowest weekly close since January 2020.

We have covered a lot of ground and have made great progress in this fight against inflation. We are moving towards our goal. We will only know when we have reached this goal – a medium-term inflation target of 2% − by looking at the economic and financial data. And we will base our actions on our assessment of these data. I hear some people say that the final rate hike will take place in September. There could be a further hike of the policy rate or perhaps a pause. A pause, whenever it occurs, in September or later, would not necessarily be definitive. Inflation must return durably to its target. We are in an environment of uncertainty and will reassess the situation and our action on a meeting-by-meeting basis...

Our aim is to lower inflation and our primary mandate is to maintain price stability in the medium term. That necessarily involves a decline in activity. The ideal solution, which is known as a soft landing, is a moderate lowering of activity in tandem with a significant fall in inflation. The second-quarter GDP figures for France, Germany and Spain are quite encouraging. They support our scenario of GDP growth of 0.9% in the euro area this year.

"We've been in an M&A recession for the last 16 months. However, in recent weeks, we have seen a healthy increase in new business activity as our clients begin to anticipate recovery. Completing transactions, however, continues to be challenging...I believe that the deal backlog feels like a coiled spring. Generally, deals not done don't go away. I don't know when the deal environment normalizes, but I do know that we have prioritized access to the largest fee pools and that our ability to execute for our clients and investors has never been better."

"Look, I'm not calling the bottom of the cycle. I'm just -- it is interesting to me that about 6 or 7 weeks ago and I think it was right around the time the market got convinced. The Fed was going to skip a rate increase. And so the active skipping sort of implies that you're really closer to the end than the middle. Our new business review committee, that's the first stage of us seeing deals jumped rather significantly. And again, I know the gut feel we have around the organization is that we are as busy as we've ever been."

- Moelis & Company ($MC ) CEO Kenneth David Moelis

[PACW] Confirms to be acquired by Banc of California in all-stock deal; PacWest stockholders to receive 0.6569 of a share of Banc of California common stock; Announces $400M equity raise from Warburg Pincus and Centerbridge

• 20%+ accretion to BANC’s 2024 Estimated EPS and immediately 3% accretive to TBVPS
• $400 million equity raise is fully committed after extensive investor due diligence
• Robust capital at 10%+ pro forma CET1; hedges and forward sales lock in a strong and liquid balance sheet at close
• $13 billion of wholesale borrowings to be repaid, resulting in a <10% wholesale funding ratio

Big debt restructuring of coming due maturities along with a founder led equity raise...

"Agreement to eliminate more than 83% of Carvana’s 2025 & 2027 unsecured note maturities and lower required cash interest expense by over $430 million per year for the next two years"

“This transaction significantly increases our financial flexibility by reducing our total debt, extending maturities, and lowering near-term cash interest expense as we continue to execute our plan of driving significant profitability and returning to growth,” the company’s chief financial officer, Mark Jenkins, said in a statement."

“Apollo is pleased to support this debt exchange agreement, which stands to significantly strengthen Carvana’s financial position while providing creditors with new first lien debt,” John Zito, deputy chief investment officer of credit at Apollo, said in a statement."

The company said Wednesday that it would exchange some of its outstanding bonds for new notes that would allow it to delay some of Carvana’s interest payments over the next two years. Unlike the old debt, the new notes will be secured by the company’s assets.

The company will also issue $350 million in new shares, with Chief Executive Ernie Garcia III and his father Ernie Garcia II, the company’s biggest shareholder, required to purchase $126 million of the offering. Company executives said Wednesday that the equity sale will provide cash to help pay creditors in the debt exchange...

Under the terms of the new exchange deal, the Garcias and Carvana agreed to pay for expenses that the creditors incurred over the past year as they formed an unconventional pact to cooperate with one another in negotiations with the company and the family.

Beauty and wellness company Oddity Tech Ltd. and its shareholders raised $424 million in an upsized initial public offering after pricing shares above a marketed range.

The Tel Aviv-based company, along with its founder and private equity firm L Catterton, sold about 12.1 million shares Tuesday for $35 each, according to a statement. Oddity had marketed 10.5 million shares for $32 to $34, a range it already had elevated on Monday.

At the IPO price, Oddity has a market value of about $2 billion based on the outstanding shares listed in its filings with the US Securities and Exchange Commission. Accounting for employee stock options, the company’s fully diluted value is closer to $2.4 billion. That compares with a valuation of $1.44 billion in connection with a secondary transaction in January 2022, according to data provider PitchBook.

Oddity adds to a string of consumer-oriented companies going public after a year-plus dearth of US listings. Since raising $365 million including so-called greenshoe shares in June, fast-casual restaurant Cava Group Inc.’s stock price has more than doubled. Discount retailer Savers Value Village Inc.’s IPO the following week raised $401 million, with its shares up 37% from their offer price.

“A lot of homeowners were able to either buy their home or refinance their mortgage at record low rates, and so they have these 30-year fixed rate mortgages where they’re just incentivized not to list their home for sale,” Egan says. “If you don’t have those homes listed for sale, then all of a sudden, despite the fact that affordability might theoretically warrant lower home prices, homeowners aren’t willing to sell — or they’re not forced to sell — into those lower home prices that affordability might theoretically warrant.”

That means the US housing market is basically dominated by existing homeowners who can afford to purchase new houses, but aren’t necessarily motivated to do so. And that in turn has helped to create a tight supply of houses, with existing inventory falling to the lowest levels on record, Egan says.

This two-tiered dynamic between current homeowners and would-be ones is also reflected in measures of affordability. While total affordability remains close to the worst level on record, it conceals a big difference between those who already own a house and those who don’t...

With no signs of supply ramping up or affordability meaningfully improving, the US may be facing one of the shortest and weirdest housing cycles ever.

“Because of the lock-in effect, we don't see supply increasing all that substantially moving forward, but we don't think you have another leg down here. We don’t see affordability improving hand over fist as we move forward, but we don't see a lot of deterioration moving forward from an affordability perspective either,” Egan says.

Zillow expects U.S. home prices to rise 6.3% between June 2023 and June 2024.

Among the 200 largest housing markets, Zillow thinks 48 markets will see a jump of 7.0% or greater

"The average homeowners insurance premium in Florida has increased 100% over the past three years, and the average cost is approximately $6,000—more than triple the national average, says the Insurance Information Institute. Florida homeowners may see average premiums reach $9,000 next year. Experts say insurance for properties near the coast can easily top $100,000."

With investor anxiety rising about types of commercial property from shiny office buildings to self-storage facilities, the low-slung structures are a rare bright spot. Retailers want to stay close to where customers are spending more time these days: their homes. The leased occupancy rate at strip center real-estate investment trusts stood at 95.3% as of the first quarter, a level last reached about eight years ago, according to real-estate advisory firm Green Street. Physical occupancy was 92.4%, right around where it was prepandemic...

One reason for strip malls’ strength is the widespread shift to a flexible working environment, which means consumers are spending more time at home rather than city centers where their offices are. Conor Flynn, CEO of Kimco Realty, the largest shopping-center-focused REIT, said during an industry conference in June that the flexible work environment has led to a pickup in visits to the shopping center. Some two million people left America’s largest cities in 2021 and 2022. Meanwhile, around 1.3 million people migrated to suburbs and exurbs, according to a report from bipartisan public-policy organization Economic Innovation Group.

On average, office occupancy remains at about half of prepandemic levels in the 10 metro areas that Kastle Systems tracks as of the week ended July 19. That means lunch demand at restaurants near offices has shifted to those at strip centers closer to people’s homes. So has demand for personal-care-type services. Schmidt said strip-center demand has been strong from businesses in that category, which includes massage and chiropractic service providers, medical laboratories and dental offices.

A January research report written by Chris Wheat, president of the JPMorgan Chase Institute, found that the number of retail establishments in city centers had declined 3.8% as of fourth quarter 2021 compared with the same period in 2019. By contrast, the number of establishments in inner suburbs rose roughly 1%. Before the 2020 pandemic, city centers saw the highest growth in establishments.

Disposals in recent months, like the $800mn sale of a resort in Texas and a $2.2bn sale of a portfolio of self-storage properties announced earlier this month, come as Blackstone is raising cash to prepare for what it believes is a “once in a generation” opportunity to build properties to handle rising computing demand from a boom in artificial intelligence.

Blackstone has committed to spend over $8bn to build new data centres for several large scale technology companies, according to two sources familiar with the matter.

The investment push is coming from Blackstone’s ownership of QTS Realty Trust, a real estate trust focused on data centres, which it acquired for over $10bn in mid-2021.

Blackstone has earmarked properties built to handle rising data needs from a surge in AI investment as a priority across the $1tn in assets group.

Large technology companies like Microsoft, Google, Meta and Amazon will need to invest about $1tn in future years to build the digital infrastructure to handle the soaring computing demand from artificial intelligence technologies, according to independent research firm Dell’Oro Group.

Blackstone has spent over $1bn in recent years to buy land to build new data centres in five states across the US, according to two sources familiar with the matter. It has also contracted power from large local utilities in order to handle the heavy energy needs of the properties it is planning to build...

Since Blackstone acquired QTS, its leased space has tripled and Blackstone is preparing to further double its size with the new investment. QTS’s valuation has soared to about $20bn, according to sources familiar with the matter, double what Blackstone paid.

Some top Blackstone officials believe the investment could become its single most profitable real estate investment.

“Large technology companies are in the midst of an AI arms race which we believe will be a once-in-a-generation engine for future growth in data centres and is driving tremendous demand on the ground,” Blackstone recently told its investors.

The worst of San Francisco’s office pain is showing signs of easing.

Demand for offices in the city grew about 10% in the second quarter from the previous three-month period, according to VTS, a commercial real estate technology firm. The company tracks demand by measuring tenants touring office properties and looking for space in key US markets.

It’s good news for San Francisco office owners who have faced pressure from record vacancies as technology firms cut back on space. Prospective tenants have been hunting for large spaces of more than 50,000 square feet (4,645 square meters) since March. The demand has been largely driven by the boom in artificial intelligence companies, according to VTS Chief Executive Officer Nick Romito.

It’s also positive for a city that’s been pummeled by the pandemic with an ailing downtown core, plagued by homelessness and open drug use. Mayor London Breed said it’s not just artificial intelligence companies, the city is also attracting life science firms needing laboratory space.

“There are at least 10 companies now in search of almost a million square feet of office space as we speak,” Breed said in an interview from City Hall on Tuesday. “We’re seeing a huge increase in the need for more office space for certain companies. And so that’s going to start taking flight.”

KKR has made a push to give an ownership stake in companies in which the private-equity firm invests to the acquired firms’ employees. As a result of the RBmedia sale, all of the audiobook company’s more than 300 employees will receive payouts as equity holders, according to Pete Stavros, co-head of global private equity for KKR.

The average payout for employees at RBmedia will equate to one year’s pay, or a minimum of $50,000, which employees will receive at the close of the deal. Employees that have been with the company for more than 10 years will receive double their annual pay or a minimum of $100,000, Stavros said.

H.I.G. is expected to continue the employee-based ownership program as a part of its investment, the first time KKR has sold to a firm that has committed to continuing the program.

“The flywheel on employee ownership is starting to turn,” Stavros said.