Weekly Investment Update (08/11/2023)

Inflation Continues Its Downward Trajectory

The disinflation trend remains solidly on track as evidenced by the July consumer price index (CPI) increasing a modest 0.2% month-on-month for both the headline and core measures. The annual headline core rate, which excludes the volatile food and energy components, ticked down from 4.8% to 4.7% while the July headline rate of 3.0% moved up slightly from 3.2% in June (largely due to base effects from a hot June reading last year). While core goods prices have fallen by the most since March 2022, core inflation has remained elevated primarily due to shelter prices, which make up roughly a third of the index. However, shelter costs appear set to decline in the coming months given their lagged nature and evidence from forward-looking indicators.

The July report, in combination with the soft June report, is likely to reassure the Federal Reserve that underlying inflation is easing. With core goods disinflation clearly underway and shelter price pressure set to ease further, we are closely monitoring the extent to which services and wage inflation can continue to moderate given a tight labor market. While additional labor market and inflation data will be released in the coming weeks, current trends point toward an economic backdrop that should allow the Fed to refrain from raising rates at its September meeting.

Second Quarter U.S. Earnings Held Up Better Than Feared

90% of S&P 500 companies have now reported their second quarter earnings. 80% of companies have beaten earnings per share (EPS) estimates, the highest since the third quarter of 2021 and well above the long-term average of 65%. Although earnings came in stronger than expected, we have still seen a 4.7% drop in year-over-year earnings with the second quarter of 2023 marking the third consecutive quarter of falling corporate U.S. profits. It is worth highlighting that if the energy sector was excluded from these numbers, then overall earnings would have been forecast to rise 1.4% year-over-year.

On a sector level, consumer discretionary earnings outperformed, highlighting continued consumer resilience. Travel continues to be extremely strong with Booking.com stating they are expecting a “record summer travel season in the third quarter” reflecting the strong jobs market and remaining excess savings. Technology results have been mixed with Bessemer holdings Apple and Microsoft declining 4.8% and 3.8%, respectively, despite their strong earnings releases while Amazon jumped 8.8% due to positive forward guidance. Regional banks performed well recently given the stabilization of deposits following bank runs in March and April. The energy sector has been the weak spot with earnings falling 50% year-on-year due to the steep decline of energy prices from the Russian Ukraine post invasion peak last year.

As we look forward, consensus is forecasting a modest earnings expansion in the third quarter followed by 7.7% growth in the fourth quarter. For the calendar year earnings are expected to marginally grow by 1.0%. A return to meaningful growth of 11% is expected for 2024.

Signs of Tighter Lending Standards Begin to Emerge

Signs of tightening lending standards, the process by which banks and other financial institutions become more restrictive in extending credit to borrowers, are beginning to appear. The Senior Loan Officer Survey, a primary indicator of credit conditions, garnered investors’ attention as it revealed that lending standards remain tight and demand for loans continues to weaken. Looking forward, banks expect further tightening of loan standards in all categories which is partly attributed to a more uncertain economic outlook. Cooling credit supply puts pressure on consumption and corporate revenues, though the economic impact is felt with a lag.

Although the effects of tighter lending standards are beginning to permeate the economy, there are limited signs of pervasive financial stress. Aggregate household delinquency rates — including mortgages, auto loans, credit cards, and student loans — remain low. While consumer loan delinquencies have begun to normalize, credit card delinquencies have increased beyond pre-Covid levels. The 12-month grace period on the restart of student loan payments is an important offset to a potential rise in delinquencies. Additionally, consumers typically have more assets than liabilities, so earning a higher interest rate on savings could also help mitigate the impact of increased interest costs.

When it becomes more difficult to borrow, companies with lower credit ratings tend to default first as they carry high debt burdens and are dependent on cheap financing. While investment grade and high yield credit spreads remain tight, the Credit Income strategy has been upgrading the credit quality in the portfolio year to date in expectation of potential volatility in credit markets favoring higher quality government securities relative to extended and lower capital structure exposures.