That’s all of the hikes, folks
Stock markets have seen a timid recovery in recent weeks.
In this post, I will talk about inflation in the eurozone giving way to a recession-like state of affairs, but fortunately equities have already fallen in price. Before that, let’s take a look at miscellaneous global economic barometers pointing in different directions. Let's also quickly review the Fed's latest interest rate decision.
Economic barometers and the Fed rate decision
Caterpillar, the global economic barometer whose yellow machines can be seen slowly repairing roads even in the Nordics, published better-than-expected third-quarter results. Caterpillar sells machinery for, e.g., the construction and mining industries. However, investors were spooked by a worse-than-expected derailment of the order book and weak Q4 guidance. This graph shows Caterpillar's order book, which explains well why such a turn makes investors cautious.
Elsewhere, semiconductor manufacturers - the sector that is often considered the second barometer - have expressed optimism about the future. Chips go into practically everything from cars to phones and computers. The sector built up huge lead times in the 2020 frenzy, but in tale as old as time, shortages and rising prices have ultimately led to overcapacity and overstocking. Samsung, the world’s largest memory maker, said that customers’ stock levels are finally starting to normalize, and the industry is recovering, driven by smartphones and data centers. Even within the semiconductor industry, there are big differences, as graphics card claptrap company Nvidia has risen to become one of the world's most valuable companies while Intel and others have struggled. The Philadelphia semiconductor index has recovered from last fall's lows, although it too has tumbled with the rest of the market in recent months.
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The Fed kept its policy rate unchanged at 5.5%, as expected. The Fed is waiting to see how the historically steeply raised policy rate will begin to quietly bite into the economy. With many households and businesses borrowing at fixed rates during the period of zero interest rates and deposit rates starting to yield comfortably, higher interest rates have done little to slow down the red-hot US economy, which grew at an annual rate of almost 5% in the third quarter.
Monetary conditions are barely on the strict side at the moment, if the Bloomberg Monetary Conditions Index is to be trusted.
On the flipside, the year-on-year change in bank lending in the economy has turned downwards. Such a slowdown has never happened except once before, during the financial crisis. As a rule, the amount of loans always increases. It will be interesting to see how this plays out over time.
Eurozone inflation recedes and recession takes its place
Preliminary inflation data for the eurozone in October provides further reasons to believe that a peak in interest rates is at hand. Consumer prices rose by only 2.9% year-on-year, down from 4.3% in September. Inflation cooled broadly, although the fall in energy prices was the main factor in the big picture. Last year's strong comparison period is now at its worst in energy. Food and alcohol price rises slowed to 7.5%. Of the above, the adjusted core inflation rate was 4.2%. Services inflation was 4.6%, with no significant fall month-on-month. Underlying inflation is a bit of a theoretical concept because I don't understand who can live without energy, food, and alcohol but it better reflects the broad price pressures in the economy. Well, you can list endless different percentages, but the main point is that inflation is coming down, although core inflation is still well above the ECB's 2% target.
Bloomberg economists expect inflation to fall below the 2% target by the middle of next year, at which point policy rate cuts could also begin. Inflation is notoriously difficult to predict, but it is good to be aware of roughly what the big forecasting houses expect in the event of anomalies. The European risk-free rate - the German 10-year bond - did not budge much on the news, currently hovering around 2.8%.
Inflation won’t cool without sacrifices. The eurozone economy contracted by 0.1% in the third quarter. If the volatile tax haven Ireland is removed from the figures, in practice the change in the size of the eurozone economy has now stagnated. According to Bloomberg forecasts, GDP should hover around the same level for the foreseeable future, accelerating to a frenetic growth rate of over 1% (for Europe) by the end of 2024. The economy of Europe’s sick man, Germany, slumped in the third quarter. The plight of German industry is well illustrated by the cry of distress from a representative of the country's chemical industry who’s suggesting that the energy-intensive industry will not survive for long when cheap Russian energy is no longer available. Indeed, the German economy is facing a period of renewal.
For many euro shares, inflation abating would be a cause for celebration. High inflation is unpredictable, which makes interest rates difficult to predict. Interest rates are the gravity of equities. Since the start of the inflation storm in 2021, the path for equities has been very rocky. As inflation recedes, the threat of a recession looms large in the minds of investors who are always on the lookout for threats. However, at least a mild recession should not come as a surprise to the stock market. This is reflected not only in the valuation, but also in the results. According to data compiled by Bloomberg, some 250 of the 433 member companies of the European STOXX600 index have reported their results. On average, sales are down by 5% and results by 20%. Only half of the results have met analyst expectations.
The figures are weak, especially when compared to the US. Excluding the seven largest technology companies, such as Microsoft and Amazon, whose results are growing at a monster pace, S&P 500 companies are expected to see their results fall by 9% in the third quarter. Sales are expected to remain unchanged. But with mega-technology, S&P500 results seem to be turning upwards already in the third quarter. Europe lacks such super-growth companies, and the stock market certainly feels it.
The European stock market costs around 11.4 times projected 12-month earnings, which is essentially the level seen in the euro and financial crisis. It's not worth paying too much for euro stocks because of the muted earnings growth outlook, but it looks cheap unless the results really disappoint.
However, the European banking renaissance looks set to be short-lived. Inflated interest income from rising interest rates now appears to be peaking, and instead results are starting to be weighed down by rising loan losses in the downturn and, in turn, by interest margins weighed down by falling interest rates. A JP Morgan analyst commented on Monday that the entire European banking sector should be shorted.
Many Finnish investors wonder about the cheapness of Nordea, which is making record profits, but the whole banking sector is trading at dumpster multiples in Europe. The forward-looking P/E ratio is below six, which is at financial crisis levels. Investors have virtually no confidence in the current performance of the sector. It's somewhat suspicious why there is such skepticism about the state of the economy's blood vessels, but you don't have to look far for bad news. I've just read how the number of companies in critical financial condition in Britain is soaring. Swedish banks are hit by the bursting of the country's property bubble. Europe, which has been marinating in a zero-interest environment for years, could be in for some surprises as rising interest rates expose companies that have taken on too much debt.
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