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1. Cash-strapped consumers are pulling back on spending
With the 30-year mortgage rate in the US approaching 8%, and the UK BBA rate at almost the exact same level, households are forking out a huge share of their take-home pay on housing. Pay packets have not kept up with this trend, or with sharply rising consumer prices, and the consumer spending is falling as a result. During the earnings season of the past three weeks, this has become apparent everywhere.
US retailer Target [TGT] reported falls in sales of everything from food and clothing, to toys. Consumer staples firms such as Kraft Heinz [KHC], Unilever [ULVR] and Nestle [NESN], whom many believed to be resistant to such consumer cutbacks, have also seen volume declines over the period. Even the holy grail of consumer staples, beer, has seen sales volumes fall, with the world’s largest brewing firms AB InBev [ABI] and Heineken [HEIA] reporting such.
During the past year, we have been highlighting luxury goods as a safe haven within the consumer space. But even here, growth has started to slow. Beauty products manufacturer Estee Lauder [EL] reported a softening in sales of skincare products, and Hugo Boss [BOSS] in apparel. It seems that even discerning consumers are becoming yet more selective the longer the squeeze on their wallets continues.
2. Defence stocks remain red-hot
Geopolitical risks are heating up. With uncertainty from the ongoing conflict in Ukraine and the flaring-up of tensions between Armenia and Azerbaijan now turbocharged by the war in Israel, it is no wonder we are being inundated with interest from investors seeking exposure to aerospace and defence stocks.
It’s been a solid earnings season for weapons makers, and while orders can be lumpy-- countries don’t order tanks in the same way consumers do dollar-shave-- the structural tailwinds are there. We now anticipate that this growth will remain uninterrupted for at least several years, considering that many countries, particularly in Europe, have underspent since the end of the Cold War. Firms like France’s Thales [HO] are in a sweet spot, given significant stakes in a broad array of major international defence projects. Thales derives more than two thirds of its defence revenues from Europe, where we expect military budgets to rise by more than a third over the next five years.
3. Home builders are feeling the pain
We've mentioned the effect of rising mortgage rates on consumer spending, but the more obvious impact is on housing itself. When the costs of borrowing get this high, households postpone plans to move, and would-be first-time buyers remain in the rental market for longer.
Homebuilders are already taking a hit. For D.R. Horton [DHI], the US’s largest homebuilder, we project new projects to fall by 10% in 2023. Meanwhile, one of the most prominent UK homebuilders, Persimmon [PSN], has seen its share price fall by almost two thirds since April 2021.
The pain of unaffordable housing doesn’t stop there. The decline in new building projects is hurting industrial firms like Caterpillar [CAT]. Building materials firms are also taking a hit, with large suppliers Saint Gobain [SGO], Holcim [HOLN], and Heidelberg Materials [HEI] all reporting decreased volumes in the third quarter. So far, many of these companies have been able to push through price increases, which has largely offset the fall in volume, but this cannot go on forever.
4. Some firms are calling the bottom on industrial orders
Manufacturing purchasing managers indexes are a key insight into the health of the industrial sector, and a quick glance at the below chart will tell you that the readings haven't been pretty. Any number under 50 means we’re in contraction territory, so its clearly been a while since the sector has experienced growth.
The industrial sector has been hit from a number of sides. First, consumer demand for almost all goods has been falling. This decline has led to industrial firms producing less, and therefore spending less on machinery and raw ingredients or precursor materials. The other issue is de-stocking: Right after the supply disruptions of the pandemic and the surge in consumer spending, most firms eagerly filled their inventories. What we have been seeing in 2023, however, is that firms are now unwinding these large stockpiles, which has hastened the fall in demand for industrial products.
Moaty industrial firms with pricing power, such as high-end toilet manufacturer Geberit [GEBN], have managed to push up prices, offsetting volume declines. But this has not been the case everywhere.
One bright spot from this earnings season has been chemical giants like DuPont [DD] and BASF [BAS] potentially calling the bottom of this customer destocking trend, raising hopes for better earnings over coming few quarters.
5. Banking profitability may have hit its peak
It’s hard to believe that a banking crisis took place just 8 months ago. Since then we’ve been through a cycle of earnings seasons: In the first one, we were focused on whether banks would survive at all. But as the year has progressed and banking share prices steadily regained lost ground, the focus has moved on to profitability.
For a decade after the global financial crisis, the financial sector wasn't a great place to be. Higher capital ratios imposed by central banks meant the banking model became less profitable. On top of this, historically low interest rates and a relatively subdued economy all crimped banks' ability to make money. The recent surge in interest rates has suddenly meant that net interest margins, the difference between what banks borrow and lend at, could once again widen.
For banks, this has brought soaring profitability, which has shone through in earnings this quarter. Our concern is that things might be heading downhill from here. With mortgage applications falling rapidly and loan losses set to increase as consumers and businesses struggle to make high interest payments, banks' profitability may come under pressure once again.
