Weekly Research Briefing: Trick or Treat

Federal Reserve officials have said for more than a year that beating inflation could require them to hold interest rates higher for longer than investors expected.

The swift run-up in long-term Treasury yields—to around 5% from 4% in early August—suggests Wall Street now agrees. As a result, borrowing costs for U.S. businesses and households are rising in ways that could allow the Fed to suspend its historic run of interest-rate increases.

Because a resilient economy threatens to slow recent progress on inflation, the impact of higher yields on the economy is set to feature prominently in deliberations at the Fed’s two-day policy meeting that begins Tuesday. The central bank, which lifted its benchmark short-term rate to a 22-year high in July, is expected to hold it steady this week. Since March 2022, the Fed has raised interest rates at the fastest pace in four decades to combat soaring inflation.

Higher yields can tighten financial conditions through lower stock valuations, a stronger dollar and wider spreads between Treasury yields and private lending rates...

Economists at Deutsche Bank estimate that with the run-up in yields since September, financial conditions have tightened enough to reduce economic activity by 0.6 percentage point over the next year, which the economists say is equal to roughly three interest-rate increases of a quarter-point each.

A similar analysis by Tilda Horvath, a former Fed economist who is now at a Geneva-based research firm called Underlying Inflation, shows the recent rise in term premiums could more than substitute for a final quarter-point rate rise that most Fed officials projected at their September meeting.

@LizAnnSonders: 3Q23 GDP +4.9% (q/q ann.) vs. +4.5% est. & +2.1% prior … strongest quarterly growth since 4Q21

@AtlantaFed: On October 27th, the initial GDPNow model nowcast of real GDP growth in Q4 2023 is 2.3%.

US companies signaled a marginal expansion in business activity during October, following broadly stagnant output seen in August and September. Manufacturers and service providers alike reported improved activity levels as the downturn in demand moderated. The rise in total output was the quickest for three months.

Demand conditions at manufacturers improved for the first time since April, while service providers saw a slower drop in new orders.

Meanwhile, inflationary pressures softened. Cost burdens rose at the slowest pace for three years, with firms moderating hikes in selling prices at the same time. The rate of charge inflation eased to the weakest since June 2020 and was slower than the long-run series average. Firms were reportedly keen to pass through any cost savings made to customers in a bid to drive sales.

@LizAnnSonders: Disinflation pressure building as prices paid component of October
@KansasCityFed Manufacturing Index fell to lowest (and first time in negative territory) since May 2020

@WilliamsonChris: #Inflation in #Germany is plummeting, just as the #PMI has been signalling. CPI now already down to 3% in October with the PMI suggesting it has further to fall.

Interstate migration and the level of existing home sales go hand in hand. Transactions in existing homes rose from an annualized rate of around 5.25 million a year prior to the pandemic to 6.5 million in late 2020 and early 2021 at the height of the migration boom, the fastest in 15 years.

Now, homes aren't selling so homeowners aren’t moving. Since the pandemic boom, existing home sales have collapsed by 40% as of last month.

We have some confirming data courtesy of the USPS, which began publishing monthly change-of-address statistics at the ZIP code level during the pandemic so researchers could track migration trends.

The USPS has complete monthly data through May 2023, which covers most of the period we’ll get population numbers for in December. The data show, for instance, that requests for change of address to the popular destinations of Florida, Idaho and Texas fell by 9.5%, 13.9% and 10.9% respectively — matched by slowdowns in moves away from California and New York — in the first five months of 2023, compared with the first five months of 2022. Existing home sales have fallen even more since May, suggesting even less interstate migration in the second half of the year.

In the past two weeks the market has apparently entered a new phase of the rising rate saga and begun to downgrade its economic growth outlook alongside higher yields. The sharp underperformance of cyclical stocks signals concern that the recent tightening of financial conditions will hamper economic growth. Unlike in September, the defensive Utilities sector has outperformed MTD despite potential headwinds from high leverage. Perceived “quality” stocks with strong balance sheets, high profit margins, and high returns on capital have continued their outperformance.

Looking forward, a further weakening of the economic growth outlook would likely support our interest rate strategists’ view that yields will not rise much further. Our economists agree with the “higher for longer” interest rate outlook espoused by most clients but believe that yields are unlikely to rise much beyond current levels on a sustainable basis. Despite this week’s 4.9% 3Q GDP print, our economists expect a deceleration in the sequential real GDP run-rate to 1.6% in 4Q. The historical experience of sharply rising bond yields suggest this slowdown would be a short-term positive for equity prices to the extent it constrains bond yields. But ultimately the market reaction to weakening growth data will depend on the magnitude of the deceleration and whether it rekindles the widespread recession fears that have characterized much of the last 18 months. While interest rates matter for equity valuations, the long-term trajectory of stock returns is determined by earnings growth, so “bad news is good news” cannot last for long.

It’s Time to Stop Crying About Bonds and Buy Them Instead

The bull case starts with the fact that today’s entry point is the best in years. Yields across the Treasury market, at about 5%, are the highest since 2007. Investment-grade corporate bonds pay an average of 6.3%, a yield not seen since mid-2009. For someone in the 24% tax bracket, a 30-year municipal with a triple-A rating yields 6.1% when its tax advantage is included. (Although junk bonds average 9%, their “spread” over Treasuries is fairly narrow, indicating they aren’t cheap.)

As bond prices decline, their yields climb. An end to the bear market would send prices higher and yields lower.

Higher yields can solve a lot of problems. If inflation were still running at 9%, the income generated by bonds would be of scant use as higher prices would wipe out purchasing power; even 5% inflation would make it a wash. Inflation, though, isn’t the worry it was just a short while ago.

Treasury inflation-protected securities, or TIPS, maturing in both five and 10 years are pricing in inflation of 2.5%, implying that expectations are well anchored. At those levels, Treasuries are generating yields of 2.5% after inflation, the first time “real yields” have been meaningfully positive in over a decade.

“The real rate is so attractive that you don’t need to venture very far out on the curve and your yield will work for you,” says Rick Rieder, chief investment officer of global fixed income at BlackRock (ticker: BLK).

@bespokeinvest: Microsoft $MSFT is the lone mega-cap above its 50-DMA as we enter the new trading week. Apple $AAPL is back to where it was six months ago after round-tripping a move from ~$168 to $195 that it had from May-July.

@TheTranscript_: FCFs are improving too: "The largest driver of the improvement in free cash flow is our increased operating income, which we're seeing across all three of our segments"

"Revenue exceeded our expectations across all major lines of business. Gross margin was 45.8%, 280 basis points better than our guidance, driven by higher revenue and ASPs and better sell-through of previously reserved inventory." - Intel Corporation CFO David Zinsner

@wabuffo: $COF (Capital One) - US credit card net charge-off rate dropped in Sept. They appear to be normalizing at levels below their pre-pandemic historical performance.

@TheTranscript_: Costar Group CFO: "What we are now seeing in the property markets are some of the worst conditions in decades. I suspect this is the first time that many people on this call have experienced high inflation and interest rates like some of us enjoyed back in the '80s & '90s.."

$OTIS - "we now believe the New Equipment market in the Americas is going to be down mid-teens, and we're really seeing that with the highest impact being the interest rates remaining high. It really is impacting new project starts"

@MikeZaccardi: Halloween spending expected to jump 15% YoY

[DECK] Reports Q2 $6.82 v $4.41e, Rev $1.09B v $958Me; Raises FY24 guidance

• Raises FY24 $22.90-23.25 v $22.36e, Rev $4.03B v $3.98Be, gross margin ~52.5-53.0% (prior: 52%)
• Raises FY23 op margin ~18.5% (prior: 18%)
• Inventory $726M v $925M
• Direct-to-Consumer (DTC) net sales +38.8% y/y
• Ugg brand $610.5M, +28.1%
• Teva brand $21.5M, -28.4%
• Hoka brand $424M, +27.3%
• Comments: The strength of demand for our HOKA and UGG brands continued to drive exceptional performance, producing record revenue and earnings for Deckers in both the second quarter and first half of fiscal year 2024.

$MCD RESULTS: Q3

• Comparable sales +8.8% vs. +9.5% y/y, EST +7.79%
• US comparable sales +8.1% vs. +6.1% y/y, EST +7.5%
• International operated markets comparable sales +8.3% vs. +8.5% y/y, EST +8.51%
• International developmental licensed markets comparable sales +10.5% vs. +16.7% y/y, EST +8.27%
• EPS $3.17, ADJ EPS $3.19 vs. $2.68 y/y, EST $2.98
• Revenue $6.69B, +14% y/y, EST $6.52B
• Operating income $3.21B, EST $3.04B

"And the consumer is clearly under pressure with inflation over the past year and pretty much everything with gas and groceries and really across the board, higher interest rates. We continue to do well not just across our income levels, but with the lower income, they're holding up really well. They're really hanging in there at the same -- at about the same level as our medium and high-income level." - Chipotle Mexican Grill CFO John Hartung

Dow component Coca-Cola Q3 results topped estimates and boosted its annual sales and profit forecasts on strong demand and higher prices/now sees FY organic revenue growth of 10%-11% (vs. prior 8%-9% view) and raises year profit to 7%-8% from prior 5%-6% view) – also said average selling prices rose 9% in Q3, while overall volumes also grew 2%.

"But despite concerns of affordability, consumer demand for vehicles remains relatively healthy. And during the quarter, partly because of improved New Vehicle supply and stable Used Vehicle inventory, we saw double-digit year-over-year growth in new vehicle sales and strong sequential growth in Used Vehicle volume. And frankly, this is the first time in 8 consecutive quarters that we've seen growth in combined New and Used Vehicle volumes for automation. So I think that's very positive." - Autonation CEO Michael Manley

"Revenue strength was driven by solid leisure demand throughout the quarter and by managed business continuing to come in largely as expected…overall, demand remains healthy.. October performance has been strong to date and bookings for the holidays as a whole are also strong." - Southwest Airlines Co. Chief Commercial Officer Robert Jordan

October 30, 2023 - Charlie Munger

We sit down with the legendary Charlie Munger in the only dedicated longform podcast interview that he has done in his 99 years on Earth. We’ve gotten to have some special conversations on Acquired over the years, but this one truly takes the cake. Over dinner at his Los Angeles home, Charlie reflected with us on his own career and his nearly 50-year partnership at Berkshire Hathaway with Warren Buffett. He offered lessons and advice for investors today, and of course he shared his speech on the virtues of Costco once again (among other favorite investments). We’re so glad that we got the opportunity to record and share this with you all — break out your notebooks, tune in, and enjoy the singular wit and wisdom of Charlie Munger.

Realty Income Corp., an owner of convenience stores, warehouses and other commercial real estate, agreed to acquire Spirit Realty Capital Inc. for $5.3 billion in an all-stock transaction.

Spirit shareholders will receive 0.762 newly issued shares of Realty Income for each share that they own, according to a statement Monday. The deal is expected to close in the first quarter of 2024.

The transaction is expected to diversify Realty Income’s tenant base, create $50 million in annualized synergies and build a real estate investment trust with an enterprise value of $63 billion, according to the statement.

Worldline SA sent a fresh shockwave through Europe’s fintech sector on Wednesday, cutting its sales outlook and warning of economic challenges that pushed its stock down by more than half.

The French-based payment processor, which services more than 1 million merchants globally, cited weakness in the German market and increasing fraud and cybercrime risks that prompted it to cut ties with some clients. The stock plunge wiped €3.8 billion ($4 billion) off the market value, lowering it to about €2.7 billion.

Investors were still digesting other bad news from the industry when Worldline issued its dramatic warning. Just a day earlier, UK-based CAB Payments Plc saw its share price drop 72% after it cut its revenue guidance. And back in August, Adyen NV suffered a selloff after the company’s first-half results fell short of expectations.

Investors are starting to lose patience with fintechs, which surged during the pandemic as lockdowns pushed more people online for shopping and other daily business. Since then, worries over lofty valuations and a broader slowdown in consumer spending amid a cost-of-living crisis have brought the high-flying stocks back to earth.

While I had both Klarman and Lynch on the line, I had to ask them about stocks. First Klarman: “The market is scary and vulnerable. The geopolitical strains seem heightened rather clearly. I think in some ways the magnitude of the disaster of the Fed holding rates at zero for a decade is now much more clear.”

As for Lynch, he says, “We’ve been in an incredible bear market for two years,” except for basically 10 big stocks. Stocks are almost selling for less than cash. Look at the Russell 2000.” Is he bullish on the Russell 2000? “Absolutely,” he says. “I love it when stocks go down.”

BlackRock Inc. predicts that the global private debt market will roughly double to $3.5 trillion by 2028, one of the most bullish calls to date on the growth of the industry.

The money manager is forecasting that “tectonic shifts” in financial markets will spur more borrowers to seek out private funds for financing, especially as some banks pull back from lending, according to a note published on Thursday by Amanda Lynam, BlackRock’s head of macro credit research.

“As the private debt market continues to grow in size, its capability to compete directly with the public debt financing markets will likely expand,” Lynam wrote, adding that there is growing appetite among institutional and retail investors for the assets.

BlackRock said it expects private debt to grow at about a 15% compound annual rate over the next five years. The market is currently estimated at $1.6 trillion and could reach $1.75 trillion by the end of the year, according to the paper. Preqin Ltd., which tracks data on the alternative investment market, said this month that private debt globally will reach $2.8 trillion by 2028.

Batteries now underpin the prodigious task of overhauling the global energy and transport system to reduce reliance on fossil fuels. While the cost to make lithium-ion batteries has plummeted, allowing electric car sales to take off in recent years, the bare bones of the technology have remained little changed since commercialisation.

After three decades of incremental optimisation, however, that orthodoxy could soon be upended. Toyota, the world’s largest automaker, has indicated in recent weeks that it is close to a manufacturing breakthrough for a potentially game-changing technology: solid-state batteries. Hype has been building since a series of announcements on the next-generation technology by the Japanese car manufacturer in June. Its market capitalisation has surged by $26bn since then.

If successful, Toyota could start selling EVs that are safer, can recharge more rapidly and can drive 1,200 kilometres on a single charge — around double the company’s current average — as early as 2027.

@charliebilello: The average price of a used Tesla is now $28k lower than the peak price in July 2022, a 41% decline. $TSLA

Byron Wien’s 20 Life Lessons

I was scheduled to speak about the world outlook at an investment conference in 2012, and shortly before my time slot, the conference organizer said the audience was more interested in what I had learned over the course of my career than what I had to say about the market. I jotted a few notes down and later expanded and edited what I said that day. Others have since encouraged me to share my thoughts with a broader audience. In the decade since, I have come back to them time and again to test their resonance and staying power, and find them still broadly applicable.

Here are some of the lessons I learned in my first 80 years, which I continue to practice as I enter my 90’s...

David Beckham is the kind of world-famous athlete whom everyone thinks they already know. In the ’90s, he joined Manchester United from humble working-class beginnings in East London, arriving on the pitch with a drive and determination to win. The public didn’t quite know what to make of him: He was both a pretty boy dating Spice Girl Victoria Adams, and a brilliant footballer with deadly free-kick accuracy. But in the 11 years he played with United, Beckham helped lead them to become the best football team on the planet, though not without serious setbacks.