KKR on the January CPI

The January CPI report strengthens our view that growth and inflation will be more resilient this year, even more than we previously thought. Against that backdrop, we expect fewer Fed cuts.

We continue to argue that we are in a Regime Change where there is a ‘higher resting heart rate’ for inflation this cycle. This report confirms our view that investors have been overly optimistic about the Fed cutting rates into an environment that is defined by low growth, low inflation, loose monetary policy, and tight fiscal policy.

That environment is one that we have permanently exited, we believe. Key to our thinking is that four drivers – more fiscal stimulus, a messy energy transition, heightened geopolitics, and tight labor markets – will make this cycle different. (…)

Despite some seasonal noise, the details suggest that Core Services inflation (the key focus area for Fed policymakers right now) remains even more resilient than we had expected.

Supercore inflation (Services inflation ex-Shelter and Healthcare) accelerated for the third month in a row and is now running at around six to seven percent annualized on a three-month moving average basis. While we think that there is some residual seasonality at play here (e.g., we saw a similar ‘blip’ around 3Q/4Q last year), it is clearly taking longer than policymakers had hoped for inflation to cool in labor-sensitive sectors.

Meanwhile, Shelter inflation unexpectedly accelerated to +0.5% from +0.4% in December, driven by a sharp increase in Owners’ Equivalent Rent. Although market rents have been on a cooler path, Chair Powell’s latest press conference suggests that he wants to see that slowdown reflected in official BLS data; all else equal, the January data will encourage Fed policymakers to take a more patient approach to rate cuts.

Netting together this month’s data (including payrolls, ISMs, and claims), we are raising our 2024 real GDP forecast even further above consensus to +2.5%, up from +2.0% previously (consensus is +1.7%). These increases support our view that we are living in a higher nominal GDP environment this cycle.

We think seasonals will push Services CPI lower by this summer (Exhibit 1), allowing the Fed to start cutting in June (vs. our prior May baseline). Our base case now moves back to three cuts this year (versus four previously), which raises our YE 2024 fed funds forecast to 4.625%. Our YE 2025 forecast rises to 3.875%, from 3.625% previously. (…)

We raise our YE 2024 10Y UST target to 4.25% from 4.0% previously, while retaining our longer-term view that bond yields settle around 4.0% (meaning 4.25- 4.5% represents reasonable value for longer term allocators).

AMERICAN EXCEPTIONALISM

Japan Economy Shrinks Unexpectedly Japan dropped a rank to became the world’s fourth-largest economy as growth in tourism spending failed to offset sluggishness in domestic consumption and capital spending.

Japan’s gross domestic product shrank 0.1% in the three months to December from the previous quarter, government data showed, weaker than economists’ forecast for 0.2% growth. The economy contracted 0.8% in the July-September quarter.

Although the economy weakened late in the year, real GDP grew 1.9% in 2023, improving on 2022’s 1.0% expansion. In nominal terms, Japan’s GDP was worth 591.482 trillion yen, or about $3.93 trillion, at current exchange rates. That puts Germany’s economy, with its 2023 GDP of about $4.42 trillion, in third spot globally. (…)

Technically, the Japanese economy is in recession, as it has contracted for two consecutive quarters. However, the data are preliminary and the drop small enough to leave room for doubt about whether the country has really slipped into recession. Revised estimates due next month could paint a different picture.

Based on the PMI surveys, Japan manufacturing is still contracting but services are a strong offset. The composite PMI rose from 50.0 to 51.5 in January

led by the fastest expansion in services business activity
in four months, while the reduction in manufacturing output eased
to a three-month low.

There was a renewed, albeit fractional rise in new order inflows at Japanese private sector firms that was the first since last September and was led by the steepest rise at service providers for four months.

Eurozone Industrial Production Unexpectedly Expands Amid Signs Recovery for Sector

Total production rose on 2.6% on month in December, according to figures published Wednesday by European Union statistics agency Eurostat, the second-straight rise, after a revised 0.4% increase recorded in November.

December’s result upended expectations of a fall of 0.2%, according to a consensus of economists polled by The Wall Street Journal.

Amid low demand and steep interest rates, industrial production had fallen in four of the five months prior to November. But purchasing managers’ survey data has shown that manufacturing sentiment has improved in each of November, December and January, indicating that there could have been some bottoming out of weakness in the sector.

Compared with December 2022, output grew 1.2%—the first time it has risen on year since February 2023.

The rise in production was driven by a 20.5% increase on month in capital goods, which incorporate assets like machinery, equipment and vehicles that are used to make consumer goods. Meanwhile, energy output climbed 0.3% on month, production of durable consumer goods rose 0.5%, while for nondurable goods it ticked up by 0.2%. (…)

But in Germany, traditionally the workhorse of European industry, the environment is still weak, with production falling there by 1.2%. In Spain, it dipped by 0.4%, while output grew in both France and Italy by 1.1%. (…)

Apparently not out of the wood yet:

New business inflows fell in January, extending the current sequence of shrinking demand that began last June. Weaker falls in new orders were seen at manufacturers and services companies, leading to the softest overall rate of decline in sales for seven months. Although new business from external clients fell for a twenty-third month in a row, January’s decrease was the least pronounced since April 2023.

Euro-Area Economy Is Losing Momentum, EU Says, Slashing Outlook

Gross domestic product in the currency bloc will accelerate only slightly to 0.8% this year after 0.5% in 2023, the European Commission said in a report Thursday. In November, it had predicted a more marked improvement to 1.2%. It also cut its 2025 forecast to 1.5%, from 1.6%

“The rebound expected in 2024 is set to be more modest than projected three months ago, but to gradually pick up pace on the back of slower price rises, growing real wages and a remarkably strong labor market,” Economy Commissioner Paolo Gentiloni said in a statement. (…)

In recent weeks, both the International Monetary Fund and the Organization for Economic Cooperation and Development cut their GDP forecasts for European countries in 2024, while revising up global expectations. (…)

So far, the deterioration in the euro-area outlook has not caused the European Central Bank to reconsider its record-high 4% interest rate, though policymakers acknowledge that borrowing costs will be reduced this year. (…)

ECB President Christine Lagarde — speaking the EU lawmakers on Thursday — cautioned again rushing into rate cuts as rising salaries becoming an ever-more significant driver of inflation. (…)

“Incoming data continue to signal subdued activity in the near term,” Lagarde said. “However, some forward-looking survey indicators point to a pick-up in the year ahead.”

Which ones Mrs. Lagarde?

• The HCOB Germany Composite PMI Output Index slipped deeper into sub-50 contraction territory in January, dropping from December’s 47.4 to a three-month low of 47.0.

 

• German Economy May Have Shrunk in First Quarter, Nagel Says
• France‘s manufacturing sector remained under intense pressure at the beginning of the year as indices for output, new orders and employment remained in deep contraction territory. The latest survey data showed another considerable month-on-month drop in new orders. France’s service sector saw its downturn extend into the new year, as client hesitancy and generally subdued demand conditions reportedly weighed on activity and new business inflows.
• France to Lower Its Growth Forecast as EU Outlook Worsens
• Driven by a renewed expansion in the service sector, the HCOB Italy Composite PMI Output Index re-entered growth territory for the first time since last May, rising from 48.6 in December to 50.7 in January. That said, the rate of increase was only marginal. New business across the Italian private sector also rose at a slight pace in January. The upturn was led by service sector firms as manufacturers continued to record a drop in new sales, albeit softening on the month.
• The seasonally adjusted S&P Global UK Manufacturing
  Purchasing Managers’ Index™ (PMI®) posted 47.0 in January,
  up from 46.2 in December but below the earlier flash estimate
  of 47.3. The PMI has signalled a deterioration in operating
  conditions in each of the past 18 months. Four out of the five
  PMI sub-components – output, new orders, employment and
  stocks of purchases – were showing trends consistent with
  overall contraction.
• UK Recession Deals Fresh Blow to Sunak’s Economic Promises

The UK and China together absorb nearly 25% of EU exports.

European banks and their $1.5 trillion commercial property headache

European banks have about 1.4 trillion euros ($1.50 trillion) in loans to the troubled commercial property industry, amid a steep fall in office prices on both sides of the Atlantic and investor concerns about lenders’ ability to handle the risk.

Banks in Germany have become a particular focus because the country is in its worst real-estate slump in decades – one marked by insolvencies, halted construction and a freeze in property deals. Investors dumped the shares of one of Germany’s top property financiers last week, concerned about its exposure to the U.S. market.

Fallout from the downturn also has the potential to affect banks in France and the Netherlands, which are among Europe’s biggest commercial real estate lenders. (…)

The real-estate sector accounted for roughly a fifth of Germany’s output, with low interest rates pulling billions of euros into property.

Industry experts say prices have further to fall. There is currently not much price transparency, with owners unwilling to sell at reduced prices and asset managers slow to revalue their holdings.

“Valuations are still too high. Everybody knows it. But at a certain point of time, people need to drop their pants,” said Alexandre Grellier, founder of Drooms, a service provider to property dealmakers. (…)

With 285 billion euros in commercial property loans, German lenders account for around a fifth of the EU banks’ 1.4 trillion euros in loans to the sector, based on European Banking Authority data. (…)

Deutsche earlier this month disclosed 17 billion euros in loans to the hard-hit U.S. commercial property market, more than 3% of its entire book. That would make up about a fifth of the 76 billion euros that EU banks overall have lent in the United States, based on EBA data.

Deutsche Pfandbriefbank (PBB), created after the global financial crisis more than a decade ago, is one of Germany’s top property financiers.

It has 5 billion euros – or 15% of its loans – tied up in the U.S. commercial market, PBB has said.

Last week, it doubled its risk provisions, and investors got spooked, dumping its shares and bonds as short sellers moved in. PBB reacted by issuing two separate announcements that sought to reassure the public about its health.

Late on Wednesday, the credit rating agency S&P downgraded PBB due to its links to commercial real estate and gave it a negative outlook. (…)

Some European banks are even bigger in commercial real estate lending than German banks, with France and the Netherlands dominating, based on EBA data. Rabobank and BNP Paribas top the chart.

Loans from French banks to the sector are slightly ahead of Germany’s, according to the EBA data, Netherlands comes in third, ahead of Italy and Spain. (…)

The ECB warned in November that the property slump could last years, although it said the sector was not big enough to create a systemic risk for lenders.

Last month, the head of Germany’s financial regulator stepped-up his warnings, predicting 2024 will be less rosy for bank profits and that real estate was an increasing risk.

Europe Earnings Haven’t Missed This Bad Since 2020

With about a third of companies in the MSCI Europe Index having reported to date, energy, industrials and consumer companies have disproportionately fallen short of expectations.

Industrials had a difficult year, with the percentage of misses steadily rising throughout 2023 as client spending dried up.

About 53% of the companies in the MSCI Europe Index that have reported so far missed estimates, while just over a third posted earnings beats. (…)

SENTIMENT WATCH

Ed Yardeni today wonders if we are in a meltup equity market. Among his evidence charts:

• High, near extreme bullishness:

• NDR has a similar reading from this chart:

• Extended equities:

• The 13,34-week EMA is also extended, but still positive:

This trend helps explain the unending rise of the Magnificent Seven.

As John Mauldin explains, “The recent rise of the “Magnificent Seven” tech stocks is mathematically dooming many others to below-average gains. (…) in 2023, less than 30% of the S&P 500 stocks were able to beat or even match the S&P 500 return.”

Harvard Slashes Healthcare Investments, Tech Rises to 98% of Portfolio

The Harvard Management Company increased its direct holdings of Alphabet and Meta and continued its major sell off of biopharma holdings — which now make up less than 1 percent of the portfolio — during the last three months of 2023.

Meta and Alphabet together make up 70 percent of the HMC’s public portfolio. Light & Wonder Inc., a company that provides gambling services, makes up the third largest stake in HMC’s portfolio. (…)

During the latest quarter, HMC sold its stake in eight of its nine biopharma companies, which are counted as part of the healthcare sector.

The persistent sell-off of stocks within the sector continues a trend that began in early 2021.

In 2020, at the height of the Covid-19 pandemic, healthcare stocks represented 67 percent of HMC’s portfolio. The holdings have now been reduced to less than 1 percent. (…)

Adding to the near total sell-off of biopharma holdings, HMC sold its full position in Grab — a Singaporean tech app — after purchasing over 13 million shares since December 2021.

HMC sold their holdings after shares declined by over 50 percent in value, the first shares were purchased at $7.13 and all were sold at $3.46 apiece last quarter. Grab was once hailed as a long-term growth investment after emerging markets experienced lowered evaluations in 2020, but failed to meet investor expectations.

HMC preserved its direct holdings in semiconductor companies, the most notable including NVIDIA, Taiwan Semiconductor Manufacturing Company, and Advanced Micro Devices. They combine for roughly 8 percent of the portfolio. (…)

Hmmm…

Let me repeat this line:

Meta and Alphabet together make up 70 percent of the HMC’s public portfolio. Light & Wonder Inc., a company that provides gambling services, makes up the third largest stake in HMC’s portfolio.

Interesting trio…

Inflation remains stickier than thought

US January CPI has come in on the high side of expectations with headline up 0.3% MoM versus the 0.2% consensus while core rose 0.4% MoM versus the 0.3% market expectations. This means the annual rate of headline inflation falls to 3.1% from 3.4% and core remains at 3.9%.

The details show the upside surprise coming from shelter, which increased 0.6% MoM, led by owners’ equivalent rent, which also increased 0.6%. Airline fares rose 1.4% MoM while medical care increased 0.5%, the same as recreation while education increased 0.4%. These last three are all the fastest rate of increase for a number of months.

We did get good news on vehicle prices, which were flat on the month for new cars and down 3.4% for used vehicles, but the report is undeniably disappointing overall.

Core CPI vs core PCE deflator, MoM%, 3M annualised and YoY%

Source: Macrobond, ING

When looking at the core PCE deflator, which is tracking considerably lower as a measure of inflation, it again underscores the mixed messaging we are getting from the US data. The left-hand chart is core CPI from today, the right-hand chart is the Fed’s favoured measure of core inflation, the core PCE deflator. What we want to see is the MoM% change (blue bars) to be below the black line (0.17% MoM) consistently to get inflation down to 2% year-on-year.

We aren’t close on CPI, but we are clearly there on the core PCE deflator. Likewise, the 3M annualised rate looks great on the PCE deflator and rather worrying on the CPI measure. (…)

Note that the PCE chart above does not include January, out at month end.

Sticky Sticky

The Atlanta Fed core sticky-price index (a weighted basket of items that change price relatively slowly, 64% weight) increased 6.8% (annualized) in January, its 3-month 6.3%. YoY: +6.5%. 

Median CPI is trending up, sharply:

• Like the 16% Trimmed-Mean CPI (which excludes the biggest outliers in either direction and takes the average of the rest):

Goldman Sachs keeps explaining every little item, monthly…

The strength largely reflected start-of-year price increases for labor-reliant categories such as medical services (+0.7%), car insurance (+1.4%), car repair (+0.8%), personal care services (+0.7%), and daycare (+0.7%). Food away from home—which flows into the core PCE—was also strong at +0.5%.

We believe many of these increases reflect the lagged effect of strong wage growth in 2023, and we believe wage growth is now slowing.

However, despite a further slowdown in the rent category (+0.36% vs. +0.39% in December), the large and persistent owners’ equivalent rent category (OER) jumped to a 9-month high of +0.56% (largest gap vs. rent component since 1995). While the OER measure has been particularly volatile recently, we note the possibility that the January strength reflected the rebounding single-family housing market, which the OER sample was reweighted to emphasize starting last year.

Used car prices declined 3.4%, a larger drop than we expected, and we continue to expect further declines in February and beyond due to rising inventories and falling auction prices. Apparel (-0.7%) and prescription drug (-0.6%) prices also declined, in contrast to our expectations. Travel categories were strong (lodging +1.8%, airfares +1.4%), contributing to the jump in core services inflation excluding rent and OER to +0.85%, well above the prior six-month average of +0.37%.

… but its 6-month chart is worrisome:

July to October numbers were promising: core CPI was rising below 3% annualized. But November-January is back at 4%+. Is it a coincidence that consumer spending (demand) was quite strong at year-end?

Services inflation (61% of CPI, 76% of core CPI) is particularly sticky, +6.5% annualized in the past 3 months. It’s not only shelter, also up 6.5% a.r. since November, Services less shelter rose 0.6% in January and is up 6.1% a.r. in the last 3 months.

Meanwhile, core goods prices perked up 0.1% in January (ex-cars), not much but it broke a long deflationary trend linked to easing supply chains and overstocked merchants, two things of the past now.

John Authers:

Breaking down the sector into shelter (whose measurement grows ever more controversial as it accounts for a bigger share of overall inflation), and the Federal Reserve’s so-called “supercore” measure of services excluding shelter, we find that the supercore is rising, while the disinflation of shelter (which should be in full swing now, to judge from real-time indexes of new leases being signed) is proceeding slowly:

Supercore matters to the Fed because it is particularly sensitive to wages. The salary bill is a large part of a service company’s budget, much of it paid to relatively lowly paid workers. The concern as inflation took hold in 2021 was that the fast inflation of the goods that people needed to buy would prompt stronger wage demands. That would push services inflation upward, and risk embedding higher expectations. The January numbers suggest that that’s exactly what is now happening. (…)

On these figures, it would be foolish to cut. The Personal Consumption Expenditure number, separately calculated and not yet available for January, suggests price rises are lower, particularly in services, and implies that cuts might already be possible.

Further hikes are hard to imagine unless the PCE shifts hard upward, but the risk of overheating or “no landing” (in which the economy carries on strong and eventually forces the Fed to tighten until it forces a recession) looks significant. “Is the Fed too tight?” asks Steven Blitz of TS Lombard. “Current data say no, future data are unclear. Hedging their bet, the Fed holds back on cutting and communicates easing. Inflation lurks.”

BTW, here’s the Supercore monthly:

One could simply dismiss the CPI and hang his hat (or set monetary policy) on the recent PCE inflation numbers, but that would be dangerous given their past relationship …

… and the fact that monthly data has been unusually favorable to PCE lately, something that can reverse quickly:

This next chart highlights how subdued monthly PCE inflation has been compared to CPI inflation since last summer …

… giving these diverging trends:

Small Business Owners Expectations for Higher Sales Declined in January

The NFIB Small Business Optimism Index decreased two points in January to 89.9, marking the 25^th consecutive month below the 50-year average of 98. The net percent of owners who expect real sales to be higher declined 12 points from December to a net negative 16% (seasonally adjusted), a very negative shift in expectations.

@RBAdvisors

State of the Credit Markets 2024

The most striking thing on the opportunistic credit side is the sheer enormity of the market right now.  We think about the addressable market for opportunistic credit in four buckets: high yield bonds, BBB-rated bonds, leveraged loans, and private credit.  The size of those four categories just prior to the financial crisis was about $3 trillion.  Today, it stands at roughly $13 trillion, so that’s a 4x increase – staggering growth in those categories. ^(…)

Spreads have been a little bit tighter in the last three or four months.  But with base rates where they are, private credit firms can potentially earn 11.5% or 12.0% coupons while lending to multibillion-dollar businesses, in situations where a private equity sponsor is writing a multibillion dollar check, usually to the tune of about 60-70% of the total capital needed to buy the company.  That’s a very attractive risk-adjusted return.

Maturities are going to start to ramp up over the next several years in a very meaningful fashion. You have over $800 billion of U.S. high yield bond and leveraged loan debt that is coming due in 2024, 2025, and 2026 – and roughly $1.4 trillion globally.

All that debt needs to be refinanced in some way.  Historically, the easiest way to do that has been by using the syndicated market.  However, the syndicated market has become increasingly selective about which borrowers it will support.  We can all look at credit spreads and say those are well within historical norms, but those credit spreads are available only to the best borrowers.

More and more, there are a lot of companies being left out that are looking for alternative solutions.  Without those solutions, most of these companies will end up in a restructuring.

Clearly, the most acute area of risk right now is commercial real estate.  That’s because the maturity wall is already upon us and it’s not going to abate for several years.

There’s a need for capital, especially for office properties where there are vacancies, rental growth hasn’t materialized, or the rate of borrowing has gone up materially over the last three years.  This capital may or may not be readily available, and for certain types of office properties, it absolutely isn’t available.

As we roll forward in time, different pockets of risk – or different dimensions of risk – may develop.  We’re probably at the beginning of a cyclical downturn, so we don’t believe it’s a good time to go heavy into cyclicals or interest-rate-sensitive asset classes, like, for example, homebuilding and building products.

Another area where we see risk increasing is among floating-rate borrowers broadly, specifically those that took on debt in 2018-21 when base rates were zero and the cost of borrowing was 5-7%.  The costs for those same borrowers are now more like 11-13%.

Generally speaking, when these companies took on this debt, the sponsors and borrowers assumed that they would see synergies or increased growth and cash flows.  Most of this hasn’t materialized.  Some businesses have grown, but they typically haven’t grown to the level that they or their owners thought they would.

Therefore, in addition to seeing a meaningful escalation in their cost of borrowing, these floating-rate borrowers have also been negatively impacted by the economy and therefore haven’t been able to grow into their capital structures.

(…) what you’re going to see over the next three years is an unprecedented wave of liability management driven by the really poor debt documents that were written over the last five years.  That is a big risk that I don’t think the market fully appreciates.

Those structures are perfectly positioned for predatory sponsor action, more commonly known as “creditor-on-creditor violence.”  If you’re in those structures and you’re not aware of what’s going to happen, you’re likely going to have a rude awakening.

We’ve seen this trend emerge to a very limited degree in 2023.  But it’s likely going to tick up in 2024, precisely because maturities are going to start to ramp up, and borrowers aren’t going to have the ability to address them through the syndicated market.  Sponsors who are backed into a corner are likely going to try everything at their disposal to save their equity.  The easiest way to do that is to pit creditors against each other and to advantage a certain set of those creditors to create liquidity for the company.

This is not like the distressed market we saw in 2007, where you could go out and buy a loan and expect to get the same treatment that you would in a normal bankruptcy or restructuring process.  These sponsors will act.  There are few sponsors who are going to be above aggressive liability management, so you should be ready for that. (…)

Moving forward, we believe we’re going to test the domestic market for treasuries.  I would pay close attention to Treasury auctions.  How do they go?  How well do they clear?  How do new Treasurys get placed, and who is buying those Treasurys?  The foreign buyers of Treasurys, which were the largest owners in prior years, may be tapped out.

Given the quantum of debt the U.S holds and the budget deficit that is upon us, it’s hard to imagine a scenario where the dollar value of Treasurys that need to be rolled every quarter or every month would actually decline.  Thus, we’re somewhat concerned about where the 10-year Treasury yield goes from here, given supply and demand imbalances.

Some really poorly underwritten debt was issued over the five years leading up to 2022.  A lot of it found its way into the banking sector.  A lot of those banks, including both regional and large banks, are sitting with big embedded losses on their balance sheets.  These losses might not have to be recognized immediately, but the people running the risk books for those banks probably feel pretty uncomfortable.  They’ll likely look to shed that risk.

They can shed it directly through loan portfolio sales.  After the financial crisis, Oaktree’s Opportunities group bought roughly 60 different pools of non-performing loans involving over $2 billion of equity capital deployment.  We may not see an opportunity of that size this time around, but there will be pools for sale out there.

A more elegant way to reduce risk is risk transfer.  We’re seeing an increase in the number of banks interested in talking to us about risk transfer involving high-quality assets that are simply mispriced – they were just purchased in an era that doesn’t exist right now.  We’re very excited about this growing opportunity. (…)

CFOs typically begin seeking refinancing solutions at least a year in advance of maturities.  As we flip the calendar to 2024, a lot of people are going to start looking at 2025 maturities and are going to be trying to find ways to address them.  Thus, we expect to see a big uptick in the demand for rescue capital, especially once CFOs start to focus on 2026 maturities.

Supply of capital is very constrained right now.  Many of the LPs that would typically provide capital to the sector are currently restrained by legacy portfolio issues and the fact that they’re not getting the distributions they anticipated.  So we except the supply of capital in this area to remain very constrained, creating attractive competitive dynamics for us. (…)