Daily Commentary

Providing succinct, entertaining and savvy thinking on global capital markets. Our goal is to provide discerning investors the most essential information and commentary to stay in tune with what's happening in the markets, while providing unique perspectives on essential financial issues. And just as important, Fisher Investments MarketMinder aims to help investors discern between useful information and potentially misleading hype.


What Investors Should Make of Windfall Taxes and Export Bans

Editors’ Note: MarketMinder favors no politician nor any political party, assessing politics and policy ideas solely for their potential market and economic impact.

Crude oil and gasoline prices may be down from this year’s highs, but households worldwide continue dealing with high home energy costs, spurring governments to consider taking action. On our shores, the Biden administration is jawboning about an Energy sector windfall profits tax and banning oil and gas exports. Britain is mulling an extension of its own temporary windfall tax, and Australia is considering an export ban and capping natural gas prices. Now, this is obviously a politically sensitive topic, so please understand that we aren’t trying to take sides or wade into the political aspect—especially on the eve of America’s midterm elections. But considering policies’ impact is an important task from an investing standpoint. In this case, while we don’t think any of these initiatives would likely be a net benefit, we doubt their imposition would be a huge new negative for stocks.

Take windfall profits taxes. The argument for them seems simple: Oil and gas companies have enjoyed bumper profits due to prices that rose for reasons outside their control this year—a happy accident, according to our politicians—while consumers have suffered. Therefore, it is only fair to tax this temporary windfall and use the proceeds to help households and businesses having trouble making ends meet. Problem is, a windfall tax discourages new investment, which is what is ultimately needed to bring prices down. Why would companies invest in future production now when governments are signaling they could raid any profits that brings? It also ignores recent history as well as the Energy sector’s cyclicality. In general, oil prices rise as demand exceeds supply. Eventually high prices incentivize new investment, which boosts production and brings supply in balance with demand. Inevitably, oil companies overshoot, creating a supply glut that pulls prices down. When that happens, they cut costs to stay afloat, which eventually reduces supply as new wells don’t come online to replace spent ones. That leads to supply shortages, pushing prices higher and starting the whole cycle anew.

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Putting America’s Diesel Situation Into Perspective

Steep oil prices have stolen headlines all year, enflamed by supply concerns after Russia’s invasion of Ukraine. Now, it seems US diesel prices are getting their turn after major US diesel supplier Mansfield Energy warned of a potential shortage earlier this week—particularly for the East Coast.[i] While it is possible such a shortage rekindles some near-term supply chain issues, we think the evidence suggests any pain would likely be short-lived. More importantly for investors, fears of potential diesel shortages have been widely discussed since March, suggesting negative surprise power for stocks is likely minimal.

 

Diesel—heavily used in transport, trucking, farming, manufacturing and heating—is a hot commodity presently. Many fear a potential shortage would worsen supply-chain issues, push inflation higher and increase the likelihood of recession. There is little data on diesel itself. However, it, jet fuel and heating oil are primary distillate fuels—industry lingo for petroleum products made from vapors emitted by heating crude oil. US distillate inventories are currently about 20% below their five-year seasonal average, amounting to roughly 25 days of reserves.[ii] (Exhibit 1) This has pushed diesel prices up about 45% y/y.[iii] Supplies are particularly low—about -60% under typical levels at this time of year—in the Northeast, where heating demand is higher. (Exhibit 2)

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Zoom Out to Gain More Perspective on Traders’ Reactions to the Fed

S&P 500 falls -2.5% on Fed rate hike.[i] That is how most coverage sums up stocks’ volatility on the day the Fed announced it will raise the fed-funds target range by another 0.75 percentage point (or 75 basis points) to 3.75 – 4.0%. Deeper analysis delves into the intraday wiggles, tying every twist and turn to the Fed’s words—and drawing big, forward-looking conclusions. We urge you not to try. There is simply too much noise in ultra short-term moves, which typically have little to do with how markets actually view the foreseeable future.

Initially, when the Fed’s release came out, markets jumped. Live blogs tied that to the following sentence in the Federal Open Market Committee’s (FOMC’s) statement: “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” Those who parse these things for a living interpreted this to mean the Fed might soon slow its pace of hikes, rendering expectations for the fed-funds rate to top 4.6% next year overwrought. Since many think stocks have paid close attention to terminal rate expectations lately, this was allegedly good news.

But then Fed head Jay Powell launched into his press conference and made numerous statements countering this view, and the more he talked the more markets fell. He warned “the ultimate level of interest rates will be higher than previously expected.” He implied he doesn’t think there is much lag between monetary policy moves and economic activity and claimed “there’s no sense that inflation is coming down” despite what he views as tightening financial conditions, leading him to conclude the Fed has “a ways to go.” The more stocks fell, the more commentators concluded that markets interpreted this forward guidance as a very bad sign indeed.

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Q3 Earnings Take Shape

With about two-thirds of S&P 500 companies reporting Q3 results, what can investors glean from them? While there were without doubt high-profile beats and misses that sent some companies’ stock prices soaring and reeling, more meaningful on a forward-looking basis, in our view, are the broader trends and what they reveal about how Corporate America is weathering this year’s storms. Scratch the surface of the overall mixed headline results, and there are strong indications that inflation, supply chain issues and other headwinds are working their way through the system. That doesn’t predict stocks, but it adds color to what markets have spent this year pricing in and suggests to us fears of much greater pain from here will likely miss the mark.

As analysts point out, earnings that exclude the Energy sector are down—not terribly much, but perhaps consistent with what this year’s mild bear market hinted at in advance. While the S&P 500’s Q3 earnings are up 3.0% y/y (combining actual results and remaining estimates), Energy’s 137.4% haul is swelling the figure.[i] Excluding Energy, they fell -4.4% y/y, the second-straight decline after Q2’s -4.0%.

The weakest sectors were Communication Services, Financials and Materials, which are facing year-over-year earnings declines of -19.2%, -17.5% and -15.7%, respectively. Declining ad revenue appears to be Communication Services biggest detractor, while Financials’ decline is partially an accounting construct—banks’ loan loss provisioning is contributing to their earnings weakness, especially after releasing reserves last year. Commodity prices’ steep drop from a year ago seems mostly behind Materials’ profit slide. All this is backward looking, which doesn’t affect forward-looking stocks fundamentally. So we wouldn’t read into any of it as signs of worse to come for the sectors in question or the S&P 500 overall (notwithstanding base effects over the next couple of quarters). Nor do we think Energy’s jump is some massively bullish feature looking forward—it is an artefact of higher oil and gas prices.

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From the Mailbag: Some Considerations About Those ‘Real’ Returns

Here is a question we have seen a few times in our mailbag this year: Shouldn’t you adjust stock market returns for inflation—i.e., discuss “real” returns? The sentiment is understandable, given the backdrop in 2022. And, lately, this has given rise to another question: Shouldn’t earnings be adjusted for inflation? But in our view, there are some pretty big drawbacks we think anyone considering these practices ought to weigh.

To start with, investors earn nominal (meaning, unadjusted) returns. Like a worker’s paycheck, that is what shows up on statements and in brokerage accounts, making them the most meaningful. Furthermore, corporate earnings and fundamentals are also nominal, so adjusting stock returns would compare apples and squirrels, since a stock is a share in a company’s future earnings.

But that is just the tip of the iceberg. When statisticians adjust economic data for inflation, the goal is to remove skew caused by rising prices. Consider UK retail sales: For much of this year, growth in sales values was quite strong. But was that because prices rose, or because Brits bought more stuff? Enter the inflation-adjusted measure, sales volumes. It fell in seven of the nine months for which we have data so far. Similarly, nominal US GDP grew 6.6% annualized in Q1, 8.5% in Q2 and 6.7% in Q3.[i] Without the inflation-adjusted dataset, we would never know whether this stemmed from rising prices or an actual increase in economic activity. Deflating the figures lets everyone zero in on what actually happened.

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What Q3 Eurozone GDP Growth Tells Investors

Surprise! After the release of US Q3 GDP last Thursday, the eurozone’s four biggest economies followed suit, with Germany stealing most headlines thanks to Q3 growth beating contraction projections and rebuking widespread recession chatter. Yet most didn’t cheer the better-than-estimated numbers. Instead, many warned the surprise beat was a passing anomaly before more troubling times ahead—especially given persistent elevated inflation. While last quarter’s data are old news, this dour reaction reeks of the pessimism of disbelief—the foundation of a recovery, in our view. 

First, the numbers: Eurozone GDP grew 0.2% q/q in Q3, topping expectations of 0.1%.[i] Of the 19 eurozone nations, 9 reported as of November 1, with 3 (Belgium, Latvia and Austria) contracting.[ii] But the common currency bloc’s biggest economies all expanded. Italy grew fastest (0.5% q/q), beating flatline expectations, as national statistics bureau ISTAT noted service sector gains offset contractions in industry and agriculture. The findings were also mixed but growthy in France (0.2% q/q) and Spain (0.2% q/q). For the former, gross fixed capital formation contributed while household spending stagnated; for the latter, tourism boosted the services sector as the country relaxed COVID restrictions. However, the Continent’s largest economy, Germany, grabbed most attention, growing 0.3% q/q. Though the first estimate doesn’t share a component breakdown, statistics agency Destatis credited private consumption expenditure for Q3 growth.

In a vacuum, the data were fine—most were slower than Q2 growth rates, but they largely beat expectations. However, “yeah, but” was the typical reaction, as most coverage found reason to be downcast. In our view, that is evidence of the pessimism of disbelief—a phenomenon in which investors emphasize negatives everywhere, even in positive news.

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Chart of the Week: It Isn’t Gold

Elevated inflation. War in Eastern Europe. Recession fears and a bear market. This has been a trying year for assets almost across the board. But with the aforementioned backdrop, many would—and still do[i]—argue gold’s merits. They claim it hedges chaos, inflation and equity risk. But there is an inconvenient truth: Gold hasn’t been spared from this year’s downturn, and a cold look at the facts should show you theories of its hedging powers are pure, 24-carat myths.

Consider our Chart of the Week, which shows you gold’s performance this year, overlaid with a few key events. You will no doubt see it began the year well, rising 12.9% through March 8’s high. That was the day the West unveiled sweeping sanctions, including UK and US plans to cease importing Russian energy products.

Exhibit 1: Gold in 2022

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An Autumn Update on US Housing

Will trouble in the US housing market spill over into the broader economy? Some analysts worry rising mortgage rates—tied to the Fed’s rate hikes—will leave would-be buyers unable to seal the deal, leading to an oversupply of new homes. That will then cause housing prices to crash—with alleged worrisome consequences for the US economy. However, while housing market data don’t look great, we don’t think a US recession is assured to stem from housing—and here is why.

Your first clue housing doesn’t drive the economy: the latest GDP report. Despite residential investment’s -26.4% annualized plunge in Q3, its worst reading since Q2 2020, headline GDP rose 2.6%.[i] Residential investment’s -1.4 percentage point detraction didn’t negate positive contributions from personal consumption expenditures, business investment and net trade.[ii] Now, GDP isn’t an all-encompassing economic snapshot, but in our view, its Q3 growth despite residential real estate’s big drop speaks to housing’s broader economic impact—or lack thereof.

While real estate often gets eyeballs, it is a volatile subcategory that comprises about 3% of GDP—thereby lacking the scale to be a meaningful economic swing factor, in our view. Recent pre-pandemic history shows residential investment’s big swings (positive or negative) didn’t drive headline GDP. (Exhibit 1)

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What Recent Data Suggest About America’s Economy

Mixed. That is the word most coverage used to describe the US Q3 GDP report, which hit the wires Thursday morning. On the bright side, the 2.6% annualized growth erased Q1 and Q2’s sequential declines and brought GDP to a fresh high, with consumer spending and business investment also notching new records.[i] But residential real estate detracted bigtime, and two of the three biggest contributors were the relatively less meaningful government spending and net trade. Looming over everything, the most meaningful segment of the yield curve—the stretch between 3-month and 10-year US Treasury yields—slightly inverted in recent days, fanning fears that recession is just around the corner. To be fair, it is possible economic conditions get worse from here. But it isn’t a foregone conclusion, and for stocks, a mild recession probably lacks much surprise power.

The GDP report did clear up one thing: It cuts against the argument that the US economy was already in recession when GDP slid in Q1 and Q2. In both quarters, consumer spending and business investment rose—and even when you factor in residential real estate’s burgeoning slide, pure private sector components overall grew. That repeated in Q3, contributing to GDP more than erasing its Q1 and Q2 slide. But deeper under the hood, the script flipped a bit. Government spending and fast-rising imports pulled headline GDP negative in Q1, while Uncle Sam and falling private inventories were Q2’s detractors. Yet in Q3, net trade added 2.77 percentage points to headline growth as exports rose 14.4% and imports fell -6.9%.[ii] That isn’t great news, considering imports represent domestic demand and the strong dollar—in theory—should have enabled businesses and consumers to import a higher quantity of goods for less money. So that is something to watch. Meanwhile, consumer spending growth slowed from 2.0% in Q2 to 1.4% as spending on goods contracted again (-1.2%) and spending on services slowed from 4.0% to 2.8%.[iii] Business investment was more of a bright spot, accelerating from 0.1% annualized growth in Q2 to 3.7%, but residential real estate’s -26.4% plunge weighed heavily on total private sector growth.[iv]

Now, we aren’t of the school that believes slowing private sector growth is an automatic prelude to a contraction. Past behavior doesn’t predict. However, we also think it is fair to presume elevated inflation forced consumers to cool their jets a bit, and that could continue. Imports’ slide could be a sign domestic demand overall is slipping. Inventories’ continued slide could mean businesses are in cost-cutting mode. A lot of this stuff is open to interpretation.

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Despite the Sound and Fury, Chinese Political Shifts Don’t Seem Surprising

Chinese stocks came under sharp pressure in Hong Kong and the US early this week, with the Hang Seng Index falling -6.3% Monday, cutting against a rise in most markets globally.[i] This came as China’s delayed economic data hit the newswires and the Chinese Communist Party (CCP) National Congress concluded, officially handing President Xi Jinping an unprecedented third term amid a restructured leadership group packed exclusively with loyalists to him. While that last part stirred much conversation and may have surprised some at the margin, overall the developments look set to extend the status quo versus some kind of huge shock.

Let us start with the smaller stuff: The delayed data. When China didn’t release trade data as scheduled on October 14—with no explanation—many feared terrible figures would come. Those fears grew more when it delayed GDP results last week, ahead of the Congress’s convening. But in the end, the data don’t support the narrative. After Chinese GDP growth slowed to a 0.4% y/y crawl in Q2, the latest release showed it rebounded to 3.9% in Q3 and beat expectations.[ii] This was as September industrial production and fixed asset investment accelerated to 6.3% y/y and 5.9% year-to-date y/y growth, respectively. It appears easing COVID restrictions and a raft of government support measures—many aimed at ailing property markets—helped buoy growth.

Headwinds remain. For example, 30 cities still face varying degrees of COVID restrictions, affecting around 225 million people.[iii] Hence, with year-to-date GDP growth through Q3 at only 3.0% y/y, China may not meet its 5.5% full-year growth target. Meanwhile, retail sales (2.5% y/y), exports (5.7%) and imports (0.3%) decelerated in September.[iv] That said, few analysts expect China to meet its 2022 growth target, and slowing in these retail and trade data just continues existing trends. Domestic and global demand have been weakening—the former more than the latter due to “zero-COVID” policies and real estate uncertainty—but China has dealt with these issues all year. They aren’t anything new.

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