Monday digest

Posted 24 July 2023

Overview: Another inflation driver turns over
Last week, markets yet again revolved around inflation, wages and profit margins. In the UK, we finally received some of the positive inflation news that has been stoking US markets. June’s consumer price index (CPI) decline to 7.9% year-on-year could be a watershed moment, giving the Bank of England (BoE) the green light to raise interest rates only by another 0.25% in August. To put this into context, last Tuesday markets were still pricing in a 0.50% hike.

The better-than-expected inflation news helped UK equity markets to storm higher on the week, egged-on by sharp falls in medium-term gilt yields (and parallel gilts price rises!). Sterling retreated from its recent highs against the US dollar, but UK stocks closed the week leading the rest of the world higher, even in UK sterling-based terms.

On the other side of the Atlantic, the US second quarter earnings season has showed that margins are finally coming under pressure across the board. Tesla withdrew its previous statement that margins would “remain among the highest in the industry,” and a cautious commentary left the door open for another round of price cuts soon. It’s not just Tesla, however, and margins have weakened substantially in other integral areas like trucking and freight (which we discuss in greater detail below). We have become used to the UK headlines about strikes, but if the US turns out to have a more entrenched inflation path because labour relations have worsened it may face the same worries as we have faced in the UK.

As the earnings season progresses, we appear to be in a new phase, where companies have lost pricing power but sales should hold up because they are not cutting labour aggressively. We will be listening very closely to what the US Federal Reserve tells us after this Wednesday’s Federal Open Market Committee meeting.

Chinese property developers are on their own
Since property giant Evergrande defaulted on its debt two years ago, the world’s most leveraged property developer has been in a lengthy restructuring process which, for the most part, has looked like artificial life support rather than a cure. Its slow-motion collapse has been a major part of China’s property crisis, and is a substantial drag on growth for the world’s second-largest economy. None of the property developer’s problems should surprise us anymore, and yet, its latest announcements cannot help but make collective eyes water. In just two years, Evergrande made losses of $81 billion. The incredible losses are driven mostly by asset depreciation, thanks to sinking values in China’s building industry. Analysts have suggested that the fact such dire figures are now being released shows an acceptance the hoped-for improvement is not coming anytime soon.

The Chinese government has seemed surprisingly uninterested in arresting the decline. The last few months have been horrendous for the ailing property sector, but policy support has been minimal. If Beijing does let large developers go bankrupt, equity and foreign bondholders will be the least protected. The distress also has big implications for China’s banks – which are among the largest financial institutions in the world. Developers’ financial struggles seriously impact banks, which will inevitably mean tighter lending conditions for everyone. That could well dampen any help that comes from the authorities.

China’s hopes of a post-Covid boom have well and truly evaporated, pushing down asset values which rallied into the start of this year. The property developers’ financial problems are proving contagious as they are weighing down on consumer and business sentiment. As such, they have been at the heart of the weak post-lockdown rebound in Chinese consumption and that has led to rising savings rates and even weaker private sector activity. This is not to say that Beijing is against growth – both words and actions suggest the opposite. However, it wants growth in productive areas and property has become unproductive. Developers may already be resigned to being given nothing more than life support.

Freight not great
There are serious questions over the health of the US freight industry at the moment. Relations between companies, drivers and other workers have become highly antagonistic, just as revenues have been falling. UPS, the world’s biggest courier, has been in the spotlight due to its negotiations with the Teamsters Union, with the two sides failing to agree wage increases for part-time workers, who make up roughly half of UPS’s unionised workforce in the US. UPS isn’t the only company under pressure. Yellow Corporation, the parent company of Holland and Yellow Freight, announced it is $50 million short of the pension contributions it owes, and remains in severe financial distress.

Yellow’s likely demise is a symbol of America’s freight recession. Early in the pandemic, the surge in transport demand created huge capacity expansion in trucking, only for companies to find themselves short of drivers. Workers’ increased pricing power meant significantly higher wage bills, eating into profit margins and worsening financial metrics. When the post-Covid boom dwindled, revenues fell sharply and firms were caught out.

Some of the bad news for freight companies is good news for US consumers. The ongoing freight recession means lower costs, while the inventory situation could also mean the easing of goods prices. This would help inflation-bruised consumers and support demand but, as ever, this has to be balanced against the increased risk of defaults. A wave of defaults hurts everyone, making finances tighter than they already are. This is not happening yet, but is very much a live possibility for the freight sector.

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