1. In October, global equity markets rebounded, with the big exception being China, which weighed on emerging markets performance. Year-to-date, equities remain significantly underwater.
This chart shows the price performance SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in orange), EEM (iShares MSCI Emerging Markets ETF in purple), and MCHI (iShares MSCI China ETF in yellow).
The Chinese stock market was the big outlier, reacting poorly to the outcome of the Communist Party Congress. Chinese Premier Xi Jinping will remain as leader for an historic third five-year term and be surrounded by loyalists in the Politburo. This concentration of power raised the concern China will be less focused on economic growth and more focused on domestic wealth inequality and national security issues. Zero-Covid policy, with associated activity restrictions, will also remain intact.
This chart shows the price performance SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in orange), EEM (iShares MSCI Emerging Markets ETF in purple), and MCHI (iShares MSCI China ETF in yellow).
Has the sell-off in stocks finally ended? We doubt it for two reasons.
First, we haven’t witnessed the widespread investor despair that typically accompanies equity market bottoms. Second, the Federal Reserve will need to continue to tighten monetary policy to lower inflation to a more acceptable level.
That said, to the extent a credit crisis does not develop, we don’t anticipate anything like the equity market carnage we witnessed in the 2008 Global Financial Crisis.
2. In September, U.S. inflation rate (as measured by CPI-U) barely fell to a 8.2% from August’s 8.3% and June’s 9.0% rate, which was the highest annual rate since the 1970s.
We anticipate inflation in the U.S. to moderate as the demand for goods continues to ease post pandemic. However, labor market challenges, structurally higher energy prices, and supply chain challenges emanating from China will put a floor on the intermediate term range for inflation.
3. US interest rates continued their rise, wreaking havoc on all major asset classes, as the Federal Reserve raised the Federal Funds Rate target by 0.75% in October. The Fed has raised the rate by 3.50% so far in 2022.
Source: treasury.gov, Two Centuries Investments
4. Corporate earnings season highlighted the impact of rising expenses on earnings growth for many companies. Ex-energy, earnings growth will be negative for the S&P 500 for the second consecutive quarter.
As of November 4, 85% of the companies in the S&P 500 had reported quarterly earnings results for the third quarter of 2022. No surprise, the energy sector continues to be the star performer. Notably, the industrial sector also has shown strong revenue and earnings growth. The communication services, financials, and materials sectors have experienced double digit earnings declines, year over year.
While revenues grew 10.5% year-over-year, earnings growth only grew 2.2% as higher expenses lowered profit margins.
Labor cost growth is the primary culprit and is currently running about 200 basis points higher than its pre-pandemic trend.
5. Many companies with seemingly robust business models have performed poorly this year. Below, I briefly discuss the issues facing META, a company which scores highly in the “brand” category of our Focused Quality equity model. I use a discounted cash flow model framework.
META, which owns Facebook, Instagram, and WhatsApp, reported earnings on October 26 after the stock market close. On October 27, META's stock price declined 24%. Year-to-date through the end of October, the stock price had declined 72%. What happened to META, a company which is one the big three, along with GOOGL and AMZN, in the growing and oligopolistic digital advertising industry?
Certainly, higher interest rates have contributed to a higher equity discount rate (all else equal, namely the equity risk premium). This factor has impacted higher growth stocks, which have longer "durations", as more of the cash flows to equity shareholders are further out in the future. GOOGL was impacted similarly. Think of it as a contributor to valuation multiple compression.
The boost in digital advertising during the pandemic has ended. The economy is also slowing and advertisers are reducing all forms of spending. META faced the additional headwind of AAPL allowing iPhone owners to change their privacy settings to limit tracking by advertisers. In other words, revenue growth has slowed.
Higher operating expenses, including higher labor costs, reduced profitability as profit margins declined. Lastly, META committed to maintaining much higher capital expenditures (over $32 billion in 2022) to develop the "metaverse" and expand their artificial intelligence capabilities. There is no guarantee these expenditures will produce anywhere near the high Return on Invested Capital (ROIC) produced by META’s core advertising business.
Comparing 3q2022 to 3q2021...
Revenues declined from $29.0 billion to $27.7 billion.
Net Income declined from $9.2 billion to $4.4 billion.
Cash Flow from Operations declined from $14.1 billion to $9.7 billion.
Capital Expenditures increased from $4.3 billion to $9.4 billion.
“Free Cash Flow” declined from $9.8 billion to $0.3 billion.
In summary, lower revenues, higher operating expenses, and valuation multiple compression hit the stock, like they have hit other growth stocks this year. But two other META specific issues have led to additional underperformance, namely AAPL’s business decision and META’s decision to spend aggressively to build a new business at as time when most companies are spending cautiously due to emerging economic growth headwinds.
6. As I was writing this monthly update, news broke about the failure of FTX, one of the largest cryptocurrency exchanges. While we await more details, I will highlight a few principles, likely applicable to the FTX situation and which we articulate to our clients who are considering investing in crypto.
1) Know the protections available, or not available, with the safekeeping of your assets.
2) Understand cryptocurrencies are illiquid, intangible assets which do not generate cash flows, at least not organically. As a result, they do not represent quality collateral for lending.
3) Be wary of a financial market exchange that has not subjected itself to the rules and best practices governing public financial market exchanges. In the FTX situation, FTX engaged in a related party transaction with the hedge fund Alameda Research.
4) Research the legal framework and creditor status that will be applicable if an insolvency occurs.