Sign up here to receive the Unhedged newsletter directly to your inbox every weekday morning.
Good morning! The recent resignation of House Speaker Kevin McCarthy has thrown a wrench into the US political machine. This timing couldn’t be better for Unhedged as tomorrow marks the beginning of our first of three weekly collaborations with historian Adam Tooze. Together, we will delve into how the happenings in Washington impact the markets, and vice versa. In the meantime, we eagerly await your emails and feedback to [email protected] and [email protected].
When the market assesses the state of the economy, what does it discern? Yesterday, we discussed the cautious nature of the stock market. One notable change is the relative performance of cyclical stocks versus defensive stocks. After months of outperforming defensives from May to August, cyclical stocks have begun to slip. This aligns with the broader trend of investors hedging, fund flows shifting towards cash, and sentiment deteriorating.
But why is this happening? Growth, as we previously discussed, appeared to be strong. Economic data consistently surprised on the upside, with “resilience” becoming the buzzword. While this still holds true, there are shifts occurring at the margins. The economy continues to beat expectations, but the extent of positive surprises is diminishing. The Citi US economic surprise index (blue line) below captures the performance of economic data relative to prior predictions. It remains in positive territory, but the decline coincides with the underperformance of cyclical stocks compared to defensive stocks (pink line):
[Insert interactive graphic]
In the world of markets, what matters most is the rate of change. Therefore, it’s unsurprising that smaller positive growth surprises would impact cyclical stocks negatively. However, assessing growth itself is currently challenging. Let’s consider one indicator of US demand growth: real final sales to domestic purchasers, which encompasses consumer spending and private investment while disregarding net exports and government spending. In the second quarter, it grew by 1.3% year-over-year, slightly sluggish but far from concerning.
According to Matthew Luzzetti, Chief US Economist at Deutsche Bank, excluding the volatile motor vehicle sector reveals a more concerning perspective on underlying demand. He suggests that underlying demand is currently at a level historically associated with recessions. Referencing Luzzetti’s chart:
[Insert Luzzetti’s chart]
In contrast, the Atlanta Federal Reserve’s widely followed GDPNow monitor paints a much rosier picture. It forecasts real GDP growth of 4.9% in the third quarter, propelled by a 2.6% increase in consumer spending. While many, including ourselves, expected GDPNow’s estimates to decline as the quarter progresses, this has yet to happen.
Whatever the current state may be, most analysts anticipate weaker growth in the fourth quarter due to a laundry list of consumer burdens (e.g., student loan repayments, high oil prices, strikes, car and credit card loan delinquencies, etc.). We agree that pressure is mounting on consumers. However, it’s worth noting that consumers have weathered worse storms. A robust labor market offsets many challenges, with most indicators of labor market tightness now at 2019 levels. While still tight, this could potentially align with 2% inflation. The question now is whether the job market will stabilize or continue its decline, an outcome that remains uncertain. In this sense, the market’s response to marginal surprises in economic data may reflect a holding pattern, waiting for the economy to become less inscrutable. (Ethan Wu)
ESG and valuations
In my recent writing on ESG, I mentioned that I hadn’t come across any recent studies highlighting the impact of corporate ESG profiles on stock valuations. Duncan Lamont of Schroders kindly responded to my query by sharing a study that he published in late 2022. After reading it, I must admit, I have reason to soften my skepticism about the potential effects of ESG on corporate valuations.
You can read the study yourself, but I’ll summarize some of the key findings. Lamont categorizes the MSCI All-Country World index into quartiles using Schroders’ SustainEx model, which measures companies’ societal and environmental impact. Naturally, companies with high scores in ESG tend to have higher valuations than those with low scores. This relationship can be attributed to sector composition differences, as sectors like materials, energy, and industrials tend to score lower due to their environmental impact and have lower valuations for unrelated reasons.
However, Lamont compares companies within the same sectors and reveals pronounced differences in valuations between the top and bottom quartiles, particularly in energy and materials. Referencing his table:
[Insert Lamont’s table]
These findings are quite significant. However, it raises an important question of causality. Are higher-scoring companies more richly valued because their businesses intrinsically align with ESG principles, or is it due to their commitment to managing ESG outcomes, or is there some spurious correlation at play? For instance, coal stocks tend to be cheaper and dirtier than other energy stocks. Are they less expensive because they’re dirtier or because coal is simply a less profitable business? To find answers, one would need to examine the index on a company-by-company basis.
However, Lamont somewhat mitigates this concern by addressing the ESG valuation premiums across sectors over time. These premiums expanded between 2019 and 2020. Observing his charts for the materials and energy sectors:
[Insert Lamont’s charts for material and energy sectors]
This is an encouraging sign. It suggests that shifting investor preferences towards ESG excellence can lead to significant valuation disparities. In turn, this could incentivize management to adopt more sustainable practices. It also presents investors with an exciting opportunity to invest in companies that have the potential for ESG upgrades in the future. However, the persistence and consistency of the relationship between ESG scores and valuations will ultimately determine the viability of these points. Some studies indicate that this relationship varies significantly across countries, while others show that periods of ESG outperformance tend to regress. Lamont promises to update his study in the near future.
Naturally, this study is not without limitations and should be approached as observational rather than a controlled experiment. Nonetheless, it provides suggestive evidence that prompts me to revisit other studies on the topic. If you have any favorite pieces, please share them with us.
One good read: The American nightmare.
Don’t forget to check out our new FT Unhedged podcast hosted by Ethan Wu and Katie Martin. In just 15 minutes, get a deep dive into the latest market news and financial headlines twice a week.
If you’re hungry for more insightful newsletters, we recommend:
– Swamp Notes: Expert insights into the intersection of money and power in US politics. Sign up here.
– Chris Giles on Central Banks: Your essential guide to money, interest rates, inflation, and central banks’ perspectives. Sign up here.
Denial of responsibility! Vigour Times is an automatic aggregator of Global media. In each content, the hyperlink to the primary source is specified. All trademarks belong to their rightful owners, and all materials to their authors. For any complaint, please reach us at – [email protected]. We will take necessary action within 24 hours.
