Capital markets perspective: Taking inaction
Capital markets perspective: Taking inaction
Capital markets perspective: Taking inaction
For every action there is an equal and opposite reaction, even if that first action is technically inaction. With me here? A handful of companies reported third quarter results that were just fine (great, even) but passed up the opportunity to issue upbeat guidance about the months ahead. There were several examples:
- Payroll processor ADP chose not to raise its outlook while acknowledging that macro headwinds were building against its small- and mid-sized business clients.
- Meanwhile, Facebook and Instagram parent Meta Platforms passed on upgrading its view because it was forced to admit that its business is “subject to volatility in the macro landscape” and “the revenue outlook is uncertain.”
- Maybe an even more resonant example is toymaker Mattel, who rode the eye-popping success of the Barbie movie to post outstanding third-quarter earnings but refused to change its tone regarding what it sees as a lackluster holiday season and weaker trends in toy sales more generally when it kept its conservative topline guidance more or less unchanged. Just like those other examples where passive inaction begat consequential reaction, Mattel was punished by markets after releasing its results for pointedly passing on the opportunity to spread some more sunshine by way of increased earnings guidance.1
It seems investors are growing increasingly skeptical that markets and the economy can sidestep more than a year of aggressive Fed tightening and a looming slowdown in growth without at least a few repercussions. While a few counterexamples come to mind (IBM, for example, did just fine post-earnings last week even though it, too, failed to be more upbeat), it increasingly looks as if it’s going to take a lot more to impress markets than it has in the recent past.
Meanwhile, other examples of action masquerading as inaction could be found last week in the world of central banking, too. For the first time in 11 chances, the European Central Bank passed on the opportunity to increase interest rates in its bid to control Euro-area inflation as policymakers acknowledged weak economic growth and a “marked” drop in inflation.2 And if rates traders are right, the Federal Reserve will follow the ECB’s lead and leave rates alone when it meets this week – Fed fund futures prices currently place the odds of an increase at pretty close to zero.3
Admittedly, the Fed’s math could be a little different than the ECB’s. Germany, the Euro-bloc’s largest economy, is pretty much already in recession while the U.S. continues to defy that designation, a point brought home most clearly last week when the Bureau of Economic Analysis’ first estimate of third-quarter GDP came in at 4.9%.4 This was way ahead of expectations and the strongest growth so far during the post-COVID recovery era. (Whether it really should’ve caught anyone by surprise is a fair question, especially since last week’s income-and-outlay data once again showed consumers performing a gravity-defying show of resilience, with a 0.7% month-over-month increase in personal spending that validated the previous week’s blowout in retail sales.5)
But one thing the Fed does have in common with European counterparts is that time is probably finally working in their favor: Remember above, where I mentioned that ECB used a “marked decline in inflation” to help explain their willingness to pass up the opportunity to increase rates this time around? They identified so-called “base effects” as perhaps the main driver of that.6 Without getting too deep in the weeds, “base effects” refers to the idea that prices were rising so fast a year ago that piling even higher prices on top of that already inflated price would make a repeat almost unthinkable. Think of it this way: If a bag of frozen peas cost, say, $1.75 at the end of the pandemic, two years of inflation would probably have taken that same bag up to around $2.59 by now.7 If inflation stays as hot as it was last year, you’d be looking at more than three bucks this time next year. I don’t know about you, but I’d rather spend $3 on clearance Halloween candy.
So all the ECB and the Fed really have to do at this point is mark time and hope that people eventually balk at paying 76% more for peas than they were a few years ago. And, if the ECB is to be believed, it seems to be working. Of course, the potential downside of that inaction is that it also risks that people will eventually balk at all kinds of other types of spending, too.
Said another way, relying on “base effects” to control inflation is kind-of-but-not-quite cheating: allowable within the rules, but not a whole lot of fun to watch. Still, there are obvious implications of this example of inaction-as-action; both the Fed and the ECB can probably afford to sit on the sidelines for another meeting or two and hopefully let the clock tick down on inflation.
And all else equal, markets will probably like that happy example of inaction. But on the other hand, “base effects” or not, it’s impossible to tell exactly how long it will take for inflation to finally erode to a point where the Fed, the ECB, and other central banks like them are comfortable backing down. That leaves the “how long?” question imbedded in the Fed’s “higher for longer” catchphrase completely unanswered. And markets don’t like that.
Two more quick points on inflation before we wrap up: First, Friday’s final results for the University of Michigan’s consumer sentiment survey weren’t any better than the preliminary results a few weeks ago; in fact, they were worse.8 Consumers now expect inflation over the next 12 months to run at 4.2%, 0.4% higher than their last guess just a few days ago and a full 1% higher than a month ago. While consumer attitudes are notoriously fickle, that’s certainly not welcome news for the Fed, who are likely far more tuned into the risks associated with inflation expectations than actual inflation numbers themselves.
And finally, let’s return briefly to frozen peas. This time, put yourself in the shoes of the producer: You may not want to charge people $3 per bag, and you may even realize that eventually people will simply quit buying from you if you do. But you’re facing higher fertilizer prices, skyrocketing transportation costs and unrelenting labor pressure. So you have to make a choice: Do I pass 100% of higher costs to my customers (and risk losing some of them in the process), or do I share the burden and take some of the hit myself? Increasingly, companies are choosing the latter. That’s commonly referred to as “profit margin compression” and has already become a more common theme in earnings results this quarter, and it’s reasonable to expect that to continue.
For those who want an even clearer picture, check out last week’s Richmond Fed manufacturing report: not exactly a hugely impactful report in and of itself, but the yawning gap between prices paid and prices received published in the back of that report shows the dilemma faced by firms struggling in an inflationary environment more eloquently than any written explanation ever could. Check it out here.9
What to watch this week
This promises to be one of the busiest weeks imaginable for economic data. In addition to a Fed decision on rates, this week will bring the whole range of monthly labor market data starting with JOLTS and its cataloguing of hirings, firings and job openings on Wednesday and continuing through Friday with the non-farm payrolls and everything that report brings with it. Also worth watching is Thursday’s layoffs report from Challenger Gray and Christmas. You’re probably tired of hearing it by now, but at some point, the U.S. labor market will have to relent. It probably won’t be this week.
We’ll also get another look at consumer confidence (from the Conference Board on Tuesday), as well as final Purchasing Managers Indices from both the Institute of Supply Management and S&P Global (formerly Markit Economics). Manufacturing results are due Wednesday, while results for the services sector will show up on Thursday. Expect each of these reports to show continued moderation in services and weak expansion (at best) in manufacturing.
And then there’s housing: Two separate reads of home prices are due on Tuesday, one from the Federal Housing Finance Agency and another from S&P/Case-Shiller. Although I didn’t mention it above, last week’s new home sales data from the Census Department showed a moderate decline in both median and average new home prices sold in September.10 While I suspect a shift in the mix of the types of homes being sold was likely at work (i.e., selling more cheap homes rather than selling homes more cheaply), if it becomes a trend and home prices do indeed relent, housing will once again become key to the economic narrative.
In the background to all this is a continued heating-up of third quarter earnings season. More than a thousand companies are expected to report on the two-day stretch including Wednesday and Thursday alone, making it impossible to single out more than a small handful of potentially market-moving releases. This week’s clear highlight will be Apple, which reports after trading hours on Thursday. Other potentially significant reports include oil majors BP and Conoco-Philips (relevant because their big-oil peers almost universally missed estimates last week) and Starbucks – home to what may be the most discretionary of spend in the average consumer’s budget. And last but not least, two big macro-relevant companies will book-end this week’s reports – Caterpillar on Tuesday and Berkshire Hathaway on Friday. Those who’ve read my comments for a while know that I view Caterpillar as a straight-through lens into the macro environment given its leverage to the capital spending and commodity cycles, while Warren Buffet’s Berkshire Hathaway is itself a microcosm of the U.S. economy (with the added benefit of a fun and insightful quarterly call by Mr. Buffet to boot).
Finally, Wednesday will bring the Fed’s latest decision on rates. As always, the decision itself will be released toward the middle of the trading day with a press conference to follow shortly after. Consider tuning in if you’re available. Otherwise, you can probably rest easier knowing that this week’s decision isn’t likely to be controversial at all. It’s always possible for some nuance to grab the market’s attention, or for the Fed to issue an unexpected rate hike to bring the labor market to heel, but barring that, I wouldn’t expect too much out of Wednesday’s decision.
1 Company reports, Zacks.com, Bloomberg
7 Empower Investments calculations: $1.75 grossed up by the CPI for all urban consumers/frozen vegetables (Bureau of Labor Statistics)
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