Monday digest

Posted 24 April 2023

Overview: prospects of a warmer Spring

Another relatively quiet week means a generally benign environment for risk assets, and recent data suggests the Spring months could be getting economically warmer. Global risk assets have been grinding higher as perceptions of external risk ebb away.

Focusing on the UK economy, Friday’s retail sales data for March marked another reduction in volumes, partly due to the cold weather, according to the Office for National Statistics (ONS). Not including fuel, the volume of retail goods sold in March dropped by 1% from February. Food price rises continue to outpace price rises in other goods (nobody is fooled by milk price cuts when the price of bananas rises more than 10%). On the other side of the coin, the Chartered Institute of Procurement & Supply indices showed that services are on an upswing. The Services Purchasing Managers Index (PMI) survey rose surprisingly from 52.2 to 53.9. Services new orders are at 55.3 and the services employment index jumped two points to 52.0 to signal a stronger hiring upswing and higher pay settlements.

Pay settlements are probably a big reason for a substantial improvement in consumer confidence. The GfK Consumer Confidence index rose sharply, although -30 doesn’t sound very confident. Historically, a better indicator is the rate of change of confidence and this has sharply improved, from a 40-year low to a 40-year high according to our calculations. The Bank of England (BoE) had expected second quarter growth would contract -0.35% (or 1.5% annualised), so last week’s run of data will be significant, and probably ensures another rate hike on 11 May. Markets are already factoring in another 0.5% rise, something which both consumers and big businesses appear able to withstand, but which will squeeze smaller companies even further.

Market volatility continued to decline last week and, as we mentioned, this helps prices to grind higher. For us, until the battle to get inflation under control is won, central banks will keep applying pressure. They’ll raise rates until the stress creates failures. The yield on riskier assets may look attractive relative to the low price movements, but the stress isn’t going away. Thus, this isn’t a Goldilocks environment of low rates, low profitability and low stress. Valuations may get more expensive, but the risks are too high to justify being overweight.

Open season on corporate earnings
Just 17% of S&P 500 companies have posted quarterly results so far, and while results are mixed, they are generally better than consensus. For 86 companies, earnings are down 1% on the year, generating against analyst expectations as of the end of March of an even lower 6 – 7% decline. Positive surprises were plus 5% – but, as ever, corporate earnings ‘surprises’ need to be taken with a pinch of salt. Over the last five years, S&P companies have beat quarterly earnings expectations by 8.4% on average. If that trend continued, we would expect a slightly positive year-on-year expansion in earnings – which is not what we are seeing so far. In fact, surprises are quite heterogeneous across sectors. Sure enough, even though US equities have beaten drab expectations so far, the S&P has traded mostly sideways over the last week.

Very few European companies have reported quarterly earnings yet, but estimates have climbed in the first few months of the year, coming down only slightly through March. European EPS estimates for 2023 are currently flat, with sales holding up but profit margins coming under pressure. This may leave European equities in a precarious position. Investors were negative about European corporate earnings In the latter half of last year, but those fears were not quite realised through a better-than-expected winter. Now that some positivity is priced in, disappointment could be ahead.

Are money market funds becoming a threat to banks?
In the aftermath of the failures of Silicon Valley Bank (SVB) and Signature Bank, American deposits have leaked out of commercial banks. Smaller regional banks have seen substantial outflows, but not all of the cash has gone to larger banks. In this day and age, most people won’t be keeping that money under their mattresses, so where did it go? For many Americans, the answer has been money market funds (MMFs). According to data provider EPFR, over $440 billion has flooded into US MMFs since the start of March. This builds on strong inflows stretching back more than a year, thanks to the US Federal Reserve (Fed)’s aggressive monetary tightening and the higher interest rates it brought.

For some investors, the inherent diversification of the underlying fund portfolios is seen as a better risk than a deposit with a single bank. But the most important aspect is that MMFs offer higher interest rates than savings accounts. The larger banks have not had to work hard to get deposits and so, currently, MMFs can give customers an enticing premium while easily convincing the financially literate/wealthy that the risks are actually less. And the difference between bank deposit rates and those in MMFs has widened over the past year, partly because of the Fed’s aggressive monetary tightening.

The current higher returns offered by MMFs, together with chaos in the banking system, is almost an investment ‘no-brainer’, but of course there are risks involved. The debt ceiling is a yearly political showdown which perennially threatens a default in the world’s largest economy. Though no one really expects the US Treasury to default on its debt, brinkmanship could well cause a liquidity crunch – as it often does – which could make it harder for MMFs to buy or sell their assets, potentially leading to losses. Banks would point out that, even if none of these concerns are likely to materialise, these are threats that MMF investors would not be protected against – unlike traditional bank accounts.

In the event of a genuine run on MMFs, the Fed would almost certainly intervene to safeguard investor capital, in the same way that the authorities went beyond their official remit to protect SVB customers. The Fed showed as much during the pandemic, when they increased reverse repo rates to effectively guarantee a minimum level of returns for MMFs. The reason for this is simply that MMFs have become so systemically important that the US financial system would likely seize up without them. The result is that Fed protection gives MMFs some of the safest short-terms available.