Banana Pancakes

A couple of weeks ago, I saw the Hawaiian-born singer-songwriter Jack Johnson in concert. As might be expected from someone who is also a former professional surfer, he is pretty chilled and his music has a great feel-good factor, which we could all use at times like these. Just for fun, I thought I would slip a few of the titles of his songs into today’s piece by way of lightening the mood (and there has already been one!).

Here we are, then, in the third week of July, and it feels as though everyone is sitting, waiting, wishing for the plaster to be pulled off. What do I mean by that? Although equity markets have been a bit more resilient in the last couple of weeks, there is still a sense of foreboding that there is another breakdown to come. And if it is going to come, let’s just get on with it, get valuations and expectations down to attractive levels and kick on with a new bull market.

The expected catalyst for the next (and, we hope, final) leg lower is a downgrade to corporate earnings expectations. These continue to hold up well in aggregate, but there are increasing signs of vulnerability. Last week, for example, Fever-Tree, the manufacturer of fancy tonic waters, reported decent revenue growth but guided to a cost-driven margin squeeze on account of a tight US labour market, the rising cost of glass (itself a function of higher energy prices) and freight and logistics disruption. It is only two months since the last update, and so while this shock has not exactly come out of thin air, it has worsened rapidly. We can only wonder how many managements took the view just a few weeks ago that the situation would normalise only to have to confess now that it hasn’t and will not any time soon. For the record, Fever-Tree guided operating profits for this year down by around a third and the shares fell about the same amount.

It reported 13% revenue growth and better-than-expected earnings for the second quarter.

Not that all is lost. The soft drinks and snacks giant PepsiCo showed how to defend profitability more successfully. It reported 13% revenue growth and better-than-expected earnings for the second quarter. But the devil was in the detail. Gross margins were lower owing to increased input costs, although the company did manage to wring more efficiency savings out of the business to drive the bottom line forward. Indeed, this is one of the reasons why I believe stock analysts have been unwilling to front-run potential earnings downgrades: it is not clear who will be best able to mitigate cost increases with offsetting cuts or productivity enhancements. No analyst (it seems) wants to make a preemptive downgrade only to discover that the company has run rings around them.

Perhaps the most extraordinary element of the PepsiCo results was the split between volumes and prices. That 13% increase in revenue was made up of 1% volume growth and 12% price inflation! That has all sorts of implications, not least for the central banks trying to reduce inflation. And one has to wonder how resilient consumers would be to further price increases, should they be necessary. One must be slightly careful about what one wishes for. If companies are too successful in passing on cost increases, then inflation is only going to be even more persistent and central banks are going to have to be even more aggressive in fighting it.

One more observation I would make here is that larger companies tend to have more levers to pull when trimming costs and generally tend to have better access to finance if required. Of course, there is also the risk that one company’s cost saving is another’s revenue loss, which can mean that this turns out to be a zero-sum game in aggregate. If you want to be more positive (and who doesn’t?), then it would be preferable if efficiency gains are the result of investment in a new technology or process and that this helps to raise productivity in the overall economy.

The fact that market-derived inflation expectations have fallen back considerably is a testament to the fact that investors do believe that central banks will have some success.

If inflation (and its second-order effects on margins and wages) is the problem for markets, what’s the solution? Much of the responsibility for getting us out of this mess lies with those who (in the eyes of many) got us into it – the central banks and especially the US Federal Reserve (Fed). It is central banks’ supposed duty to remain one step ahead of economic developments, to “remove the punchbowl” before the party gets too rowdy and/or to apply cold compresses and administer pain relief to alleviate hangovers. The Fed (and others) clung to the “inflation is transitory” narrative for too long and will now have to engage in a bigger course correction. The fact that market-derived inflation expectations have fallen back considerably is a testament to the fact that investors do believe that central banks will have some success. Still, we have to bear in mind that this is largely because they will also be successful in depressing demand (which is the only side of the supply-demand equation that they can really control).

Is it any wonder, then, that the market is tying itself in knots trying to discount the short-term risks of lower growth against the longer-term view that the Fed will be able to start reducing interest rates as early as next year? I quickly read Howard Marks’s book Mastering the Market Cycle when it appeared in 2018, but I thought it worth re-reading in the current environment. Mr Marks is the co-founder of Oaktree Asset Management, a company that invests predominantly in corporate bonds, and he has (now) almost fifty years of market experience. His memos are essential reading for informed investors. One of his key assertions is that markets (and market psychology) are subject to a pendulum effect, whereby the bigger the boom, the bigger the bust (and vice versa). He also observes that it is rare, if not unheard of, for markets to revert to mean valuations and stop right there; they tend to move further on into undervalued or overvalued territory, depending on which direction the pendulum is swinging. Consumer psychology is subject to the same swings, and one has also to fear that, having been too lenient, central banks might well err too far on the side of caution.

No doubt there are a lot of ifs and buts in here and it will pay to keep an open mind based on the evidence we see. Still, it might also be beneficial if markets calm down a bit and stop trying to overinterpret every single morsel of economic data that is released. The daily moves in interest rate and bond markets, especially, are unnerving at times, with one index of bond market volatility at high levels associated with past crises.

Mr Marks reprints in his book a cartoon of a man watching a financial market report on television. The talking head is saying: “On Wall Street today, news of lower interest rates sent the stock market up, but then the expectation that these rates would be inflationary sent the market down, until the realisation that lower rates might stimulate the economy pushed the market up, before it ultimately went down on fears that an overheated economy would lead to a reimposition of higher interest rates”. (With appropriate acknowledgement to Bob Mankoff.) That sums things up all too well for me at the moment.

I tend to digress in these commentaries, I know, and so I will keep it at that for today. Having got this far, do you remember the title? I couldn’t find any way of squeezing banana pancakes into the text (although I just did!). I don’t even like bananas, and they don’t seem to like me. But I love pancakes, especially the big fluffy Canadian ones topped with butter, bacon and maple syrup! My mother-in-law makes the best, and I hope, if she reads this, she will rustle some up during my forthcoming summer holidays. And if you correctly identified all ten Jack Johnson songs, mix yourself a piña colada and find a hammock for the rest of the day.

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