YWR: $18 Beer = Bank stocks
Disclosure: These are Personal views only. Not investment recommendations
Let’s start with two things that just look wrong. These are things where the image goes into your optic nerve, but then skips the normal route of cerebral processing or logic circuits, and instead goes to some other part of your brain and emits a powerful and unpleasant sense of wrongness across your entire body. I came across two of these this week.
Wrong thing #1. $18 Michelob Ultra at a PGA tour event. I see this and my cortex is trying to justify how this is a sporting event where prices are always high, and yes, the cans are bigger, but then some other part of my brain steps in and says, “No. This is totally stupid. Michelob is awful, even if you stick the words “ultra” on it, which by the way there is nothing ultra about Michelob. The fact that somebody at Michelob, the golf course, the PGA, or whatever, thought this was an acceptable price for a can of watery beer is wrongness to the core. But it also tells us something about what is happening to inflation expectations.
Wrong thing #2. Policy rate expectations for 2023. Obviously, not as wrong as $18 beer, but this table also stopped me in my tracks. 2% inflation in 2023 looks wrong. The Fed at 3% I think is going to end up being too low, but even more interestingly, the ECB at 0.5% and Japan still at -0.1% could also be massively wrong. I know we have all been whipsawed around by inflation expectations up and down with COVID and supply chains, and I also thought by now we should see falling inflation as the global economy cools, but the Russia-Ukraine war as thrown a dangerous spanner in the works. Let me explain.
At the beginning of 2022 I remember discussing the chart below at an investment committee. Goldman was expecting the supply chain issues to resolve around May or June and by the end of 2022 we would have headline CPI under 3%. It was my view too. My view was/is there would be a surprising fall in economic momentum as the stimulus checks and fiscal spending dropped away and companies overshot on inventory.
The Ukraine-Russia war has changed this nice scenario of gradually falling inflation. Instead we are almost into June and inflation impulses should be moderating (as in the chart above), but instead we have natural gas shooting the lights out at $8, diesel at $5, wheat at $12 and Urea at $1000/ton. There were already tight supply underpinnings to all of these commodity prices, but they are being exaggerated by the huge disruptions out of the Ukraine and Russia. So instead of moderation we are going into 2023 with inflation accelerating across food and energy driven by problems which have nothing to do with the level of interest rates.
Which brings us to this next uncomfortable chart. In past tightening cycles the Fed has always had to raise their policy rate to at least equal or above the rate of inflation. There is a dynamic where as the Fed raises rates inflation starts to fall so the two can end up meeting somewhere in the middle, but in this case that would still suggest the Fed needs to hike to 5%. 5%…. The Fed at 5% in 2023 could also mean the ECB and BOJ at 2%.
I imagine this could create a yield curve with the Fed at 5% on the short end and US 10 years possibly at 2.5%, ie, highly inverted as the market sees this is going to be a recessionary disaster. 12 years of encouraging companies, consumers and governments to over leverage themselves and then you do a rug pull. The other unpleasant aspect to this is that we will have non-stop Fed incremental rate hikes through 2022 and early 2023. It will feel like a never ending waterboarding torture.
There is the debate about whether the Fed will just give up, accept inflation is going to be high, stop the policy rate at 3% and save the equity market. That’s what short-term interest rates are expecting, but the problem is we are now 2 years into this inflation problem, about to go into year 3, and a 3% policy rate with inflation at 5%-6% or 7% is still too accommodative. Even at 3% the Fed is still too low and the problem will continue to get away from them. The Fed has to nip this in the bud to some extent.
This all seems very negative, but one highly hated and under owned sector is going to love it, European banks. Ever since the GFC European and UK banks have suffered from consistently falling net interest margins. Falling rates were great for tech stocks, but awful for banks. It has been 10 years of pain, but the tide is turning and the valuation set up is one of the best ever. Start going over the earnings results and see what happens if net interest margins expand by 50 bps over the next 2 years. What if it is 75bps or 1%? Do the math on that.
Earnings revisions trends are already surprisingly positive, but if this high inflation scenario continues into 2023 and the ECB has to move to 50bps or 1% it will kick off another level of upgrades. Banks will be the new energy or coal mining sector.
Oh, one other interesting tidbit from the banking sector. If you are an energy company or wealthy entrepreneur and think it would be a great idea to invest in a new natural gas project, don’t go talk to BNP Paribas (historically one of the largest banks for energy finance). No, natural gas at $8 and BNP is to reducing its upstream energy loan book by 12% in line with their ESG goals. High LNG prices might be around for longer than we think.
Best Graduation Party Ever
I’m still recovering. Last night was my daughter’s high school graduation ceremony and it was the best party I’ve been too in a long time. High school parties are the best. There was the standard diploma ceremony, but then afterwards cocktails and a DJ. The DJ brought the house down. The volume was machine gun to the chest level high (grandparents loved it) and the DJ was mixing in great songs with chunky beats. It was like Kid Cudi in Project X. Loved it.
Have a great weekend.