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Good morning. Speaker of the House of Representatives Kevin McCarthy is absent, throwing a spanner in the works of the American political machine. Good timing for Unhedged: tomorrow we’ll do the first of three weekly collaborations with historian Adam Tooze, discussing what events in Washington mean for the markets, and vice versa. In the meantime, we are waiting for your emails: email@example.com And firstname.lastname@example.org.
When the market looks at the economy, what does it see?
Yesterday we talked about the cautious stock market. One important change is the relative performance of cyclical stocks versus defensive stocks. Cyclical stocks have started to fall after months of outperformance from May to August. This fits into a broader picture of investors engaging in hedging, fund flows moving towards cash and deteriorating sentiment.
But why? The growth, the last time we talked about it, seemed strong. The economic figures have positively surprised time and time again. For a while, “resilience” was the key word. This remains broadly true, but the picture changes at the edge. The economy is still positively surprised, but the optimistic surprises are decreasing in magnitude. Below is Citi’s US Economic Surprise Index (blue line), which shows how economic data is performing against previous expectations. It’s still well into positive surprise territory, but to a lesser extent. That decline coincides with the sloppier performance of cyclical stocks compared to defensive stocks (pink line):
Markets care about the second derivative: changes in the rate of change. So it’s not surprising that smaller positive growth surprises would weigh on cyclical stocks.
However, the growth itself is currently difficult to understand. Take a simple indicator of US demand growth: real final sales to domestic buyers, the sum of consumer spending and private investment, ignoring net exports and government spending. This gives a gestalt picture of underlying demand, as it is largely unaffected by fluctuations in global growth or US policy decisions. In the second quarter, growth grew 1.3 percent year over year, a bit slow but far from terrible.
Matthew Luzzetti, chief US economist at Deutsche Bank, points out in a recent note that the elimination of autos, a sector that has been exceptionally volatile of late, puts growth in sharper focus. He says underlying demand is at levels historically consistent with a recession. Luzzetti’s graph:
In contrast, the Atlanta Federal Reserve’s much-discussed GDPNow monitor is much rosier. It forecasts real GDP growth of 4.9 percent in the third quarter, driven by a 2.6 percent increase in consumer spending. GDPNow has been looking impossibly high for a while, and most people (us included) suspected it would drop over the course of the quarter. It hasn’t happened yet.
Whatever happens now, most analysts expect weaker growth in the fourth quarter as consumers suffer from a litany of problems (student loan payments, $100 oil, strikes, car and credit card loan delinquencies, et al.) .
We agree that pressure on consumers is increasing. But consumers have seen worse. A strong labor market compensates for a lot of misery. Most labor market tightness indicators have returned to 2019 levels, still tight but possibly consistent with 2 percent inflation. The question now is whether the labor market will stabilize or continue its decline, which is likely unknowable. In this sense, markets trading along with marginal surprises in economic data may represent a holding pattern, waiting for the economy to become less opaque. (Ethan Wu)
ESG and valuations
The last time I wrote about ESG, I mentioned that I hadn’t seen any good recent studies on the impact of companies’ ESG profiles on stock valuations. Schroders’ Duncan Lamont responded by sending me one, which he published in late 2022. It’s good, and gives me a reason – not to say a conclusive reason – to soften my skepticism about ESG’s ability to influence company valuations.
You can read the research yourself, but here are the highlights. Lamont sorts the MSCI All-Country World index into quartiles according to Schroders’ SustainEx model, which measures companies’ impact on society and the environment. Of course, high scorers in the SustainEx model, or any other ESG scoring system, will typically have higher valuations than low scorers. This is a reflection of the sector mix: for example, materials, energy and industrial sectors are often “browner” than technology and also, for completely different reasons, have lower valuations.
But Lamont makes comparisons within sectors and finds that the differences between the top and bottom quartiles are also pronounced there, especially in areas such as energy and materials. His table:
This is a striking result. But there is an important causal question here. Are the higher-scoring companies more richly valued because their businesses are intrinsically ESG-friendly, or because of the way they are managed for ESG results, or because of a spurious correlation? For example, coal stocks are often cheaper than other types of energy stocks, and also dirtier. But are they cheaper because they’re dirtier, or because coal is generally a bad thing? You have to scroll through the index almost by company to find the answers.
But Lamont makes another point that somewhat alleviates this concern. He shows the ESG valuation premium of different sectors over time. Overall, the premiums have been broadened in 2019-2020. His charts for the materials and energy sector:
This is a hopeful sign. It suggests that changing investor preferences for ESG excellence could potentially lead to large valuation gaps, which in turn could provide management incentives to change their practices. It would also provide investors with a great opportunity to invest in companies that have ESG upgrades in the future. But both points will depend on whether the relationship between ESG scores and valuations is persistent and consistent academic article has suggested that the relationship between countries varies widely; another finds that periods of ESG outperformance, whether caused by rising valuations or something else, are often reversed). Lamont promises to update the paper soon.
Obviously, this is not a carefully controlled study: it is essentially just a map of correlations. But it is suggestive, and it has made me look again at other studies on the subject. If you have any favorites, please send them along.
Read carefully once
The American nightmare.