Timing and Earnings
By the end of 2022, we will have raised rates from .25% to 4.75%, the fastest rate rise in modern times. Larry Summers said, “This is probably going to be a textbook case of crisis creation followed by crisis mismanagement.” Investor sentiment is very negative due to continued negative price momentum, the ongoing implications of Russia/Ukraine, inflation prints and the Fed’s ongoing reaction to inflation data. Yes, the Fed waited too long to raise rates after printing record amounts of stimulus in response to COVID. We’ll never know the reality of the alternative (the Fed raising rates in 2021 instead of 2022). Now we have to deal with the aftermath of mistiming the rate hikes.
On a positive note, companies are now forced to take their financials more seriously. In the longer run, this is always a healthy lesson. Mega-cap growers like Amazon are transitioning their businesses to emphasize earnings and cash flows. Cash flow focused businesses now have to focus on positive earnings as well. Companies without healthy cash flows or earnings are now forced to address the structural issues of their business models. The pressure to operate with healthy financials can be painful and will lead to more layoffs.
The market has not yet figured out who will continue to struggle and who will adapt and thrive in the face of tighter financial markets. We’re starting to see another round of healthy earnings numbers with many positive surprises. The GFC (global financial crisis) taught all companies to hold onto more cash. As a result, most public companies have been better positioned during this downturn and the 2020 COVID crash. Despite the intense pressure, the high yield spread, an indicator of bankruptcy risk, has barely budged higher this year. The lesson from this downturn, “always maintain a path to profitability,” will also persist.
We’ve seen just about every elevated commodity price return to some level of normalcy. Shelter and housing remain the most challenging inflation number. Not only is housing and shelter 40% of the inflation index, but it’s also the slowest to move. JP Morgan released a report this week expecting inflation to fall to 3.2% by September 2023. This prediction seems aggressive, but that would be quite positive for markets.
Rate hikes are getting expensive. It’s nice to earn 4.5% on short-term treasuries while you wait to deploy capital into new investments, but the US Government has to pay for that interest. By next year the US government interest expense due to rate hikes will top $1 trillion. Biden’s 2022 budget assumed Treasury Bills would stay below 1% until 2025 and below 2% until 2030. The US expanded its debt by 4x over the past 25 years without increasing the cost of debt service because rates kept falling. There is growing budgetary pressure to keep rates low and the cost of servicing that debt at reasonable levels.
Lack of liquidity is the most immediate issue in markets right now. Fortunately, panics related to liquidity are typically resolved quickly.
VC buying stocks – an odd move
A handful of VCs opted to buy stakes in public companies like Square, DoorDash and Carvana. The VCs involved in this case are mega-funds like Andreessen and Sequoia. These VCs may behave like activist investors and help these businesses turn around during a crisis in their business model (particularly Carvana). Given the size of these funds, they can pretty much do whatever they want. The lines between venture capital and private equity have been blurring for many years. With valuations where they are, I wonder if more VCs are considering stepping outside their mandate to buy public companies at better terms than they are currently facing.
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