Weekly Research Briefing: Meteor Showers

Investor preference for a handful of themes and stocks has pushed relative valuations to extreme levels, especially for "quality" attributes such as high vs. low profit margins and strong vs. weak balance sheets. The top 20% of S&P 500 stocks on quality currently trade at a 57% P/E premium to the lowest quality stocks, a valuation gap ranking in the 94th percentile since 1995.

“Comp sales were up 2.5% in the quarter. We outperformed near competitors on both comp sales and comp guest counts. Certainly, overall QSR traffic in the U.S. remained challenging as visits across the industry by low-income consumers once again declined by double digits versus the prior year period...This bifurcated consumer base is why we remain cautious about the overall near-term health of the U.S. consumer.” – McDonald's CEO Christopher Kempczinski

Road trips to the US decreased for a seventh straight month as Canadians ramped up their American boycott.

Canadian-resident return trips by automobile from the neighboring US slumped 36.9% in July from a year ago, Statistics Canada data showed Monday.

Return trips by air from the US also slid 25.8%, while those from other countries grew 5.9% as Canadians traveled elsewhere.

The drop in US travel underscores Canadians’ resentment toward their southern neighbor, who is their biggest trading partner and was once their favorite vacation destination.

Our estimates imply that US consumers had absorbed 22% of tariff costs through June but that their share will likely rise to 67% by October if the later tariffs have the same impact over time as the earliest tariffs.

This also implies that US businesses have absorbed more than half of the tariff costs so far but that their share would fall to less than 10%. This net impact on US businesses likely masks that some companies have absorbed a larger share of tariff costs, while some domestic producers shielded from import competition have raised their own prices and benefited.

The heavy-equipment maker said Tuesday after reporting earnings that it expects to face net incremental tariffs of $1.3 billion to $1.5 billion this year — including as much as $500 million in its third quarter — though its new CEO said the company will be able to offset the impact.

Caterpillar’s outlook is important because it is one of the world’s biggest makers of machinery for mining and construction. The US manufacturer’s second-quarter results already reflect the effect of tariffs, with costs coming in at the top end of its estimated range disclosed in April.

“We’re going to mitigate the impact of tariffs,” Chief Executive Officer Joe Creed, who succeeded Jim Umpleby in May, said on an earnings call. “Exactly which levers we’re going to pull, we’re looking for a little more clarity before we reach into those.”

But now that many of Mr. Trump’s tariffs have officially set in and his trade policy seems to be solidifying, many companies are concluding that they can no longer afford to hold back.

On earnings calls with investors this week, public companies including the shopping conglomerate QVC Group, the footwear brand Allbirds and the eyewear vendor Warby Parker openly talked about their tactics to handle the escalating tariff costs, including increasing prices.

“I think we can, over the medium term, mitigate the impact of tariffs,” Andrew Rees, chief executive of the footwear brand Crocs, said on Thursday. He outlined plans to raise prices, reduce business expenses and wring savings out of the company’s supply chain, including by negotiating with factories…

Working off the assumption that tariffs for Vietnam and India would settle around 10 percent, and China around 37.5 percent, Mr. Barr (Barry Barr, the founder of KAVU True Outdoor Wear) increased retail prices for his company’s summer 2026 line by about 15 to 30 percent — the most he believed customers would pay. Under the new pricing, the retail cost of a pullover made in China would rise to $120 from $90. A button-down shirt produced in India that used to retail for $80 would be $105.

But with the tariff rates settling higher, Mr. Barr is now worried he will have to raise prices even more. The United States’ trade deal with Vietnam, for instance, stipulates a 20 percent tariff on goods from the country, and India is facing 50 percent tariffs.

At the same time, KAVU’s preseason sales for next summer came in 15 percent lower compared with sales for this summer season.

With his profit margin shrinking and business expenses already shaved to the bone, Mr. Barr said he would probably have to lay off some of his 28 employees in the next three to four months.

“You’ve got to save money somewhere so the company can move ahead,” he said.

Small businesses are significantly raising prices in response to President Trump’s tariff regime that came into effect this month, in a development that could fuel inflation in the world’s biggest economy.

Businesses surveyed by the Financial Times in the Midwestern city of St Louis said their suppliers had increased prices for a broad range of products in recent weeks, sometimes by as much as 30 per cent, leaving them with little choice but to pass this on to customers.

Many said they had stockpiled products priced at the pre-tariff level before the levies came into force, but have since run these stocks down.

“I believe inflation will increase as each item that was in inventory is replaced by a new one,” said Justin Breckle, chief executive of Authorized Appliance, a St Louis business that sells high-end kitchens, barbecues and washing machines.

“What we’re seeing with new products is they’re all being marked up,” said Mike Weiss, owner of the Big Shark Bicycle Company, which runs a chain of bike shops in St Louis. “We’re seeing an average 10 per cent increase in the retail price.”

Small US companies, the source of more than half of the country’s job creation in recent years, are struggling to comply with President Donald Trump’s new tariffs and cope with growing financial strains clobbering them from higher import costs.

Last week’s country-specific levies varying from 10% to 50% landed with a one-two punch: additional red tape issued by Customs and Border Protection, and a need to increase customs bonds — guarantees that companies must buy from surety providers to ensure the government receives its tariff revenue, other taxes and any potential penalties.

Big firms often have in-house resources to handle such administrative changes and costs, but compliance and forecasting in the new tariff regime are “where the smaller companies are really struggling,” said Erin Williamson, vice president of US customs brokerage at Levallois-Perret, France-based Geodis, a leading global logistics firm.

“They may not have that internal compliance group or the infrastructure to really sit back and say, ‘OK, this is going to be the impact to us. How do we pivot?’” Williamson said in an interview Friday.

The US Chamber of Commerce estimated this month that the country has about 236,000 small-business importers — those with fewer than 500 employees. The goods they bought from abroad were worth more than $868 billion in 2023.

Based on an estimate before Trump’s duties took effect Aug. 7, the combined annual tariff hit to those companies is $202 billion, according to the chamber, the nation’s largest business lobbying group. That works out to about $856,000 per firm a year.

Katrina Golden, the owner of Lil Mama’s Sweets & Treats, got an email this past spring from the Chinese company that supplies her branded paper coffee cups. Tariffs were coming, it said. If she placed a bulk order right away, she could lock in the price at the time of $225 a case.

“I would have loved to,” said Ms. Golden, whose coffee and cake shop operates out of a hospital in downtown Augusta, Ga. But as a small-business owner, she didn’t have that kind of extra cash. “My bottom line wouldn’t allow me to.”…

Increasing costs are hitting Ms. Golden at Lil Mama’s, too. Overall, she figures the cost of her supplies and ingredients — flour, parchment paper, napkins, paper plates, forks, butter, sugar, cream cheese, spices, plastic wrap — is up 20 to 25 percent since January.

Ms. Golden has about a 60-day supply of small coffee cups left, she said. She expects that the price of a case will rise to $300 or $400, from $225, for her next order.

And it’s not just foreign-made items. The clam shell containers for single-serve pieces of cake come from an American company. In January, a box of 500 was $55; now it is $69. A five-pound bag of coffee beans from a local roaster in Augusta is $63, up from $55. And with a new 50 percent tariff on Brazil, one of the largest coffee exporters, she expects prices to rise even further.

Higher costs and unpredictability are rippling through the labor market. “I would hire two more today if I knew that I could afford to keep them,” said Ms. Golden, who currently employs four people. But with whipsaw policy changes, “how do you plan?”…

The squeeze is playing out at Lil Mama’s. Ms. Golden’s weekly net revenue once averaged $2,500 to $3,000. Recently, she has been struggling to make $2,000. If something doesn’t change within the next three months, she said, she will have to raise prices. Fifty cents to a dollar more on a small $3 cup of coffee; $5 instead of $3 for a serving of red velvet cheesecake or banana pudding cake.

“If we fail,” Ms. Golden said, “that’s it. There’s no fallback.”

ISM Services Prices Paid for July shows that inflation pressures in the service sector are intensifying, pointing to upside risks to CPI inflation over the coming months, see chart below.

At the same time, employment growth is slowing down and the unemployment rate is rising.

The sources of this stagflation impulse are tariffs, deportations and the depreciation of the dollar.

BoA: Core PCE has been essentially unchanged at 2.8% y/y over the past year, 80bps above the Fed’s target, and we expect inflation to move more offsides in the near-term as tariffs are increasingly passed onto consumers.

A simple simulation of % y/y core PCE inflation shows we could cross 3% y/y core PCE in July. Indeed, this is precisely our current forecast, though we could be off by a month. Our own forecast may also prove too optimistic, as effective tariff rates are settling at levels above our current assumptions. That means we see risks of higher peak inflation, a longer period of inflation above 3%, nonlinearities building, and upward pressure on inflation expectations.

With inflation risks so firmly titled to the upside, we believe it is prudent for the Fed to be patient in determining its next policy move. If the economy is facing a mild bout of stagflation, as we suspect, then cutting rates could lead to a credibility-damaging start and stop cutting cycle.

In a speech at a bankers’ conference in Colorado Springs, Colo., on Saturday, Bowman said a bleak jobs report last week reinforced the concerns that led her to dissent against the central bank’s decision to hold rates steady in July rather than cut.

Bowman said that the apparent weakening in the labor market outweighs the risks of higher inflation ahead. She said she expects to support three rate cuts over the Federal Reserve’s three remaining meetings this year.

“With economic growth slowing this year and signs of a less dynamic labor market becoming clear, I see it as appropriate to begin gradually moving our moderately restrictive policy stance toward a neutral setting,” Bowman said, according to a published text of her speech.

Nvidia and AMD have agreed to give the US government 15 per cent of the revenues from chip sales in China, as part of an unusual arrangement with the Trump administration to obtain export licences for the semiconductors.

The two chipmakers agreed to the financial arrangement as a condition for obtaining export licences for the Chinese market that were granted last week, according to people familiar with the situation, including a US official.

The US official said Nvidia agreed to share 15 per cent of the revenues from H20 chip sales in China and AMD will provide the same percentage from MI308 chip revenues. Two people familiar with the arrangement said the Trump administration had not yet determined how to use the money…

The quid pro quo arrangement is unprecedented. According to export control experts, no US company has ever agreed to pay a portion of their revenues to obtain export licences. But the deal fits a pattern in the Trump administration where the president urges companies to take measures, such as domestic investments, for example, to prevent the imposition of tariffs in an effort to bring in jobs and revenue to America.

There are reasons state capitalism never caught on before. The state can’t allocate capital more efficiently than private markets. Distortions, waste and cronyism typically follow. Russia, Brazil and France have grown much more slowly than the U.S.

Chinese state capitalism isn’t the success story it seems. Barry Naughton of the University of California, San Diego has documented how China’s rapid growth since 1979 has come from market sources, not the state. As Chinese leader Xi Jinping has reimposed state control, growth has slowed. China is awash with savings, but the state wastes much of it. From steel to vehicles, excess capacity leads to plummeting prices and profits.

The U.S. hasn’t fared any better. Interventions made in the name of national security or kick-starting infant industries lead to boondoggles like Foxconn’s promised factory in Wisconsin or Tesla’s solar-panel factory in Buffalo, N.Y.

State capitalism is an all-of-society affair in China, directed from Beijing via millions of cadres in local governments and company boardrooms. In the U.S., it consists largely of Oval Office announcements lacking any policy or institutional framework. “The core characteristic of China’s state capitalism is discipline, and Trump is the complete opposite of that,” Wang said in an interview.

North American M&A announcements accelerated to $346bn in July, from $180bn in June, and the pipeline of announced deals with potential IG funding implications spiked to $423bn the highest since Apr 2019 .... Up until July the M&A pipeline has generally been declining since 2022. The YTD average of $280bn is down from $304bn average in 2023 and $346bn average in 2022.

Activist investor Engine Capital has built a stake in Avantor and plans to push the life-sciences company to sell itself or make other changes, according to people familiar with the matter…

Engine believes the company should either pursue an immediate sale or make changes that could include a board refresh, increased stock buybacks, cost cuts or selling noncore parts of its business, the people said.

Engine thinks the entire company could sell for between $17 and $19 a share, according to the people. Shares closed Friday at $11.50.

The investment firm also believes shares could trade as high as $26 apiece by the end of 2027 if the company were to make the necessary changes on its own, the people added.

For the 30-year period from 1989 to 2019, the US healthcare sector closely tracked technology returns, and with considerably lower volatility (15% vs 24%). Things have changed markedly since then, as shown on the right. The current large cap pharma forward P/E of 15x doesn’t sound that distressed, but Eli Lilly is 40% of the S&P 500 Pharma Index and trades at a forward multiple of 31x. Remaining pharma stalwarts like Merck, Pfizer and Bristol Myers trade at forward P/E ratios of just 8x-9x; biotech trades at one the largest RoE discounts in the entire market; managed care sector returns have collapsed; and life sciences and medical device companies have been hurt by cuts to the NIH, CDC and other scientific research organizations.