It’s worse than we thought!
By David Nelson, CFA
The debate over peak inflation and whether it’s arrived or still lies in front of us really doesn’t matter anymore. Whatever metric you’re using, retail giants Target (TGT) and Walmart (WMT) along with a host of other retailers have confirmed our worst fears.
It’s worse than we thought (Click on charts to expand)
Last week two of the largest retailers on the planet Target (TGT) and Walmart (WMT) both saw their stocks collapse the most since the crash of 1987.
CEO Doug McMillon of Walmart and Target’s CEO Brian Cornell surprised the street both saying they have not been passing on all of the increased costs from rising energy prices and fractured supply chains.
The obvious conclusion is that by letting margins fall in the face of increased costs to defend market share, prices would have been even higher pushing up inflation expectations beyond what’s been reported.
We can point to a lot of data driving costs higher. A catastrophic war in Ukraine and COVID lockdowns in China are both obvious suspects. Add a dysfunctional U.S. Energy policy that was little more than a payback to an extreme wing of the party, it’s not surprising the financial hit isn’t worse.
Energy touches every line item of the income statement. It doesn’t matter whether you’re a big industrial complex, a small business or just a commuter traveling to and from work. Rising energy costs hit your bottom line and in the case of Walmart and Target if you don’t pass that on to your customers, your stock price is going to take the brunt of the pain.
Any rational view of a greener society has to include an all of the above approach. Natural Gas, Oil, Solar, Wind, Geothermal, Nuclear, Hydro all of it. You can’t now turn to the fossil fuel industry begging them to increase production after throwing them under the bus and not even permit the pipelines to transport the product.
For most of the year the biggest hits to stock prices were taking place in the high-flying tech sector. In a rising rate enviornment that forces multiple compression or valuation reset it wasn’t surprising that companies generating little, or no profits fell the most.
The FOMC and Washington both have their fingerprints on the weapon
It’s common knowledge that the Fed overstayed their welcome and pushed a quantitative easing policy long beyond its intended goal. Washington doesn’t get a pass either. Their fingerprints are all over the weapon as well. The administration flooded the system with even more capital when the economy was already starting to ramp up and still looks to implement some parts of a Build Back Better plan adding more fuel to a raging inflation fire.
The R Word
The above has now shifted the conversation from inflation to the dreaded R word Recession. In technical terms a recession occurs when you have two quarters of economic contraction. They can be relatively mild to something as severe as the Financial Crisis.
12 Recessions since World War II
Let’s take that off the table right now. While there’s always the possibility of a Black Swan lurking out there some of the key conditions that fueled the Financial Crisis don’t exist today. The biggest being that banks are well capitalized.
Predicting recession is difficult at best and often not recognized until you’re looking in the rear-view mirror. In fact, we may be in a recession right now. That’s why most economists deal with probabilities because in fact we can’t be sure. It doesn’t have to be the end of the world.
If nothing else, it washes away the excess speculation and misallocation of capital setting the stage for the inevitable next leg of a bull market.
What if there is a recession?
So, what happens to markets in a recession framework. Goldman’s David Kostin put together this next chart showing the median of market declines in a recession is -24%.
Earnings hit during a recession
Earnings and profits are the fuel that drive stock prices. On average they get hit about 13%. This is where it gets important. The other side of the recession sees significant earnings gains. On average about +17%. The deeper the recession the bigger the bump in earnings.
On Friday we barely escaped closing in bear market territory ending the week off -18.6% from the highs last year. Of course, the NASDAQ has been there for some time with a closing low of close to -31%.
It was a brutal week for equity investors and by 1:30PM Friday, the S&P 500 was sitting at the lows of the year. Perhaps a little seller’s exhaustion or big traders heading home early but the remainder of the session found support from buyers looking to get long or at least cover some of their shorts. By the close of the session the SPX managed to push just above the flat line into positive territory. We’ll see if we get any follow through on Monday.
Not a lot in the way of earnings this week but given the carnage in retail, Tuesday’s earnings from Best Buy (BBY) and AutoZone (AZO) will get a hard look. Best Buy deserves the most scrutiny in that Target CEO Brian Cornell highlighted big ticket items like TVs as a source of weakness.
Please feel free to reach out with any questions. Have a great week.