There are some enormous challenges facing the global economy right now. Many are unfamiliar challenges that have not been faced for decades, such as high inflation and energy shocks. Others are well-known challenges that repeat throughout countless market cycles such as the withdrawal of liquidity, and waning risk appetites as speculative markets pull back from record highs seen only a matter of months ago.
Let’s take a look at some of these issues and their potential impacts on a few markets in the coming months.
The first thing to monitor is the state of the consumer. Most investors know that consumption is the key to modern economies. It’s the fuel that keeps those fires burning. In the US, consumption is approximately 70% of GDP.
However, inflation is high and earnings and wages are struggling to keep up. Here’s the latest ‘real’ earnings data from the US:
Simplified, ‘real earnings’ are the increase in earnings once you subtract inflation. For example, if inflation is 5%, while earnings are increasing by 4%, the reading would be -1%. The current reality is less rosy. As the labour report notes:
*Real average hourly earnings decreased 2.6 percent, seasonally adjusted, from April 2021 to April 2022. The change in real average hourly earnings combined with a decrease of 0.9 percent in the average workweek resulted in a 3.4-percent decrease in real average weekly earnings over this period. *
Despite all of the media coverage of the “great resignation”, and the change in power balances between labour and employer, wage increases aren’t keeping pace with inflation.
Which means less purchasing power, and what economists call a lower marginal propensity to consume. To me and you, that simply means people will be spending less.
Last month, a US consumer spending report showed that the American public was struggling with high gasoline prices taking a greater share of their monthly incomes. This matters because it could mean people spend less on discretionary goods and services, and more on essentials.
If we take a look at discretionary consumption companies such as Netflix, we saw people cancelling their subscriptions in the last earnings report, which was a big driver of the most recent downside.
But Netflix is now down 76% from the highs… Surely this isn’t just because a couple of million subscribers decided to cancel. (For context, that’s less than 1% of the 221 million total Netflix subscribers).
Markets are now challenging all of the assumptions about the future that were taken for granted before. Investors and analysts don’t know whether people can continue spending like they have been. Low and generally stable prices of essentials like energy and food left more capacity for discretionary spending.
Now, Oil has established itself above $100. Even though China’s consumption is lower due to their Covid lockdowns, oil hasn’t really responded to that lower demand as some might have expected.
Food prices are increasing too. We posed the question Is your food about to get more expensive? at the end of last year. The price of wheat (and other soft commodities) has jumped in recent months:
And this is going on as central banks around the world increase interest rates. Higher rates bring into question the viability of many companies that didn’t really turn enormous profits, especially those that relied instead on revenue and subscriber growth. The narrative was ‘growth’ at all costs. Much like the famous “Field of Dreams” quote “build it and they will come”.
They came in droves during the most recent market cycle. The question now is perhaps “will they stay?”, or “who will they stay with?” in the case of direct competitors.
Before, households would subscribe to various services and streaming services were growing together. Now, there are question marks over who will ‘win’ as consumers tighten their belts.
Where Netflix lost subscribers last quarter, Disney took on 7.9 million new Disney+ customers, beating Wall Street estimates of 5.3 million new customers. You won’t need to buy a subscription to see the latest instalment of Streaming Wars: Disney+ vs Netflix. It’s playing out already. Netflix has told employees that ad-supported tiers could launch before the end of the year, according to the New York Times.
Higher Interest Rates: The Great Unknown
The business world has gorged on a tsunami of cheap debt over the past decade or so. As interest rates increase, how much more of the free cash flow will now go on higher debt servicing costs?
How much higher will the cost of debt servicing in the future be when companies need to roll the debt further into the future? Especially the companies that relied on growing revenues rather than increasing profits.
Arguably that’s a large part of the reason we’ve seen tech stocks, and the US100 in particular, struggling. The index is now trading below the 12000 level…
None of this necessarily means the end for any of these companies, it just means that the story is changing along with the valuation method/assumptions that underpinned the previously higher prices.
In Europe, higher interest rates once again face off against the idealism of the Eurozone project and the single currency. The differing needs of the Eurozone nations come to the fore. Even though higher interest rates are seen as necessary to bring inflation down, different eurozone economies have different debt-servicing requirements. For example, Germany’s economy and debt to GDP ratio of 69.3% contrast enormously with Italy’s ratio of 150.8%.
The ECB is set to hike rates in Q3, with a cohort of policymakers talking up the prospects of a July hike. What will higher rates mean for debt-servicing costs? These are the same kind of concerns that preceded the 2010-2012 Eurozone sovereign debt crisis.
The BTP-Bund spread (difference between Italian and German 10 year bond yields) is one key data point to monitor the market perception of this risk, and considerations about the potential impact on the euro if Eurozone breakup fears emerge once again.
EURUSD is currently closing in on the 2016/17 lows around 1.0340/50:
And in a recent Bloomberg survey, 60% of FX strategists saw EURUSD hitting parity rather than the alternative 1.10 scenario.
Remember, these are all risks, not certainties, and anything can happen. May we forever live in interesting times!
Not investment advice. Past performance does not guarantee or predict future performance.
