The Fed and the market are both right

Good morning. Money is pouring into money market funds as investors seek safety: $286bn in March, the FT reports. While that is not a massive shift relative to the size of the US banking system (it is less than 2 per cent of the $17.5tn of bank deposits) it shows that nerves remain on edge. On a scale of 1 to 10, how nervous are you feeling? Email us: robert.armstrong & ethan.wu.

The Fed and the market disagree, and they are both right

The two-year yield is the bond market’s most sensitive barometer of Federal Reserve rate policy, and since last Wednesday — the day of the Fed’s press conference — it has fallen by almost half a percentage point, to 3.77 per cent. That’s a lot, and it’s especially a lot given that what the Fed announced on Wednesday was a 25 basis point rate increase, and that the Open Market Committee’s “dot plot,” showing each member’s future policy expectations, shows there is at least one more hike to come this year.

This divergence has driven a lot of talk about either the market calling the Fed’s bluff or the Fed making a mistake. We don’t see it this way: instead, this is a case where different kinds of actors, with different priorities, behave differently. The Fed is saying “inflation is still way too high, and we will continue to tighten until we see more evidence of a deflationary slowdown,” and the market is saying “we bet that evidence is just about to appear”.

This is a marked difference from the last bout of Fed-markets divergence, earlier this year. That involved an underlying dispute over economic reality: was inflation about to glide down fast or grind down slow? Now, markets see a credit crunch forcing the Fed’s hand on rate cuts and the central bank, while not disagreeing, is waiting to see. The Fed is staying true to its mandate, and investors to theirs. (Armstrong & Wu)

Commercial real estate, again

As commercial real estate (CRE) rises up investors’ worry list, we’ve been thinking about how high it sits on ours. What, exactly, are we supposed to be scared of?

We can think of three ways to frame the fear. First, CRE hurts regional banks. Falling office occupancy and rising interest rates depress property valuations, creating losses for the regional banks that do the majority of CRE lending (see Friday’s letter). Second, regional banks hurt CRE. Stricter lending standards post-SVB deprive commercial property borrowers of reasonably priced credit, crimping their margins and pushing up defaults. Third, both hurt each other, and the whole thing becomes a horrible, ugly downward spiral.

That last bit is what worries Paul Ashworth of Capital Economics. He wrote in a Friday note:

there is a growing downside risk that the stresses on small banks and commercial real estate develop into an adverse feedback loop; with small banks reining in lending, which causes an uptick in commercial real estate loan defaults, which drives capital values down further increasing [loan-to-value] ratios and forces small banks to increase their loan loss provisions, which triggers an even greater tightening in bank lending standards. In a worse-case scenario, we could have a rolling crisis that lasts for years — echoing what happened during the [1980-90s savings and loan] crisis.

Throw in erratic deposit flight and the whole thing gets even scarier; we all saw what happened to Credit Suisse.

But what might break the doom loop? The inflation problem looks less severe than in the run-up to the S&L crisis, meaning rate cuts can still intervene if and when inflation comes under control. Other lenders, like CRE-focused investment trusts or private equity funds, could also offset the shrink in regional bank lending. Or perhaps the unwinding will be sufficiently slow-moving that regional banks can muddle through. This chart from MSCI’s Jim Costello, breaking down maturing CRE loans by type and by year, made us feel a bit better:

Of the $400bn in loans coming due this year, less than $50bn sits directly on regional banks’ books. Though regional banks did a boatload of CRE origination in 2021-22, those loans won’t mature for years (see, eg, the light blue bars in 2026-27). Loans packed into commercial mortgage-backed securities are the biggest chunk coming due in 2023. But as Kiran Raichura, also of Capital Economics, pointed out to us last week, the Fed’s new lending facility is taking agency CMBS collateral at par, lessening any pressure on banks. Costello adds that distress levels, even for office properties, remain modest, though they are climbing. This suggests that the regional banks have some breathing room, and the longer they can stall, the more time for rate cuts to ride to the rescue.

We’ll have more to say on this in the coming weeks. For now, though, we think the biggest source of worry is regional banks harming CRE. The doom-loop scenario can’t be ruled out, but policy support and a less-than-terrifying maturity structure should help the regional lenders stay afloat. Their margins, however, may not be spared. (Ethan Wu)

The “A” trade

Tech has rallied this year, but not enough to rescue the Faangs (or, more precisely, Faangs plus Microsoft). Indeed, of the six monster tech companies, Apple is the only one with positive shareholder return since tech peaked in late 2021, and the only one that has not lagged the S&P 500. Perhaps the group should be known simply as “A” now, raising the question: can a single letter constitute an acronym?

What makes Apple different from the rest? The consensus view is that the company is more defensive than the other five, and that’s mostly right. The business models of Netflix and Meta are, suddenly, under acute competitive pressure. Amazon is suffering an acute post-pandemic hangover, as sales in its retail and web services businesses both slow quickly. Microsoft is chugging along nicely but, at 36 times forward earnings, was trading at an unsuitable premium in 2021 (it’s at 28 now). Apple, by contrast, has a loyal customer base that shells out for services and is locked into an upgrade cycle.

One way to look at the differences among the members of this motley group is by decomposing the decline in the stock prices into changes in valuation and changes in earnings estimates since late 2021:

In the case of Netflix, for example, all of the damage has been done by a falling valuation. Forward-year earnings expectations for the company are higher than they were in later 2021. The market has lost faith in the long-term growth outlook for the company, even near-term earnings hopes have hung in there. In the case of Meta, by contrast, while there was a valuation haircut, most of the damage has been done by a 30 per cent decline in earnings estimates. The business is under pressure right now.

The stock that looks odd to us in the above chart is Alphabet, which has only seen earnings estimates fall a little, but has seen a very large decline in its valuation. Microsoft looks similar, but as just noted it was very expensive in 2021. Alphabet was cheaper then (27 times) and yet has received an even bigger relative hit to its valuation since (knocked down to 21). Why?

The standard answer is that as a digital advertising business, Alphabet is highly cyclical, so worries about an impending recession have hit its shares harder than, say, Apple’s. But we don’t quite buy this idea. Advertising is cyclical, but Google’s advertising tools are now stitched deeply into corporate budgets, a basic cost of doing business. We’re not sure how cyclical the business will prove to be. As an illustration, here is a chart of Google’s annual sales growth, compared with Apple’s. 

Some of the variability in Apple’s revenue has to do with product cycles and so forth, but all the same, Google comes out of the comparison looking pretty good. Its stock is, to us, the most attractive of the bunch.

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