Techs good, transports bad

Good morning. Yesterday’s GDP report showed an economy firing not on all cylinders, but on a single, very powerful one. Real consumption, led by surging car buying (Rob did his part), soared 3.7 per cent in the first quarter, more than offsetting a small decline in fixed-investment. The contribution from consumption to GDP growth is the highest it’s been since mid-2021. The US consumer is heaving an otherwise moribund economy along.

Can it last? Bears were quick to note the effects of warm weather in January and one-off cost-of-living adjustments to benefits payments. Those could fade fast in the second and third quarters, especially as labour market fragilities worsen. “Welcome to the recession,” wrote Ian Shepherdson of Pantheon Macroeconomics.

We think it could play out more slowly. Financial distress remains subdued for low-income consumers, housing may be exiting the freefall stage and margins are still chunky enough to forestall mass lay-offs. Enough strength left over, in other words, to put off a recession for now. Think we’re wrong? Email us: [email protected] and [email protected].

Techs vs transports

Four of the five mammoth technology companies (Meta, Amazon, Alphabet and Microsoft) have now reported, and colour us impressed. Revenue is holding up, cost-cutting has come through and margins at the core business segments are improving. Is Big Tech back?

Meta, up 14 per cent yesterday, is still shovelling money at the metaverse but investors seem happy to ignore that as long as profitability is improving elsewhere. Though revenue in Meta’s core ad business fell in the first quarter, costs fell even more, lifting operating margins to 40 per cent from 34 per cent in the fourth quarter. The company guided towards stronger second-quarter revenue, with still more cost cuts to come.

Alphabet rebounded from a sluggish fourth quarter, with ad revenue posting a 2 per cent increase year on year. That bit of resilience was welcomed by investors, though Google is still trying to pull off the delicate balance of rising capital expenditure on data centres and cloud computing while cutting costs elsewhere. Operating margins, at 25 per cent, worsened a bit, and are well short of the 30 per cent margins of early 2022. But (as Lex notes) with its ad business sturdy enough and plenty of cash on hand, Google is buying time with $70bn in buybacks while it competes in the cloud.

Google has good reason to do so. Both Microsoft and Amazon’s earnings showed envious growth in cloud computing, including 22 per cent in year on year first-quarter Azure revenue growth and 16 per cent for AWS. Both companies also had sticky growth in their traditional business lines. Microsoft’s enterprise software revenue and Amazon’s US retail sales both grew 11 per cent in the first quarter.

The business of moving electrons around on silicon wafers is prospering. The business of moving bulkier things around, however, is struggling. Here is Shelley Simpson, president of the trucking company JB Hunt, commenting on a 7 per cent year over year decline in revenue in the first quarter:

We’re in a challenging freight environment where there is deflationary price pressure for an industry that continues to face inflationary cost pressures. Simply stated, we’re in a freight recession.

Here is the chief executive of another freight hauler, Old Dominion, commenting on a 4 per cent decline in revenue and a 12 per cent decline in volumes for the quarter:

While our volumes stabilised during January and February as expected, we have not seen the acceleration in volumes that was originally anticipated. Our shipments per day have remained consistent on a daily basis so far this year, but on a year-over-year basis, shipments in April are trending down double digits.

Finally, here is Carol Tomé, chief executive of UPS, commenting on the company’s 6 per cent revenue decline:

In the US, relative to our base plan, volume was higher than we expected in January, close to our plan in February and then moved significantly lower than our plan in March, as retail sales contracted, and we saw a shift in consumer spending . . . discretionary sales are lagging grocery and consumable sales, and disposable income is shifting away from goods to services.

We have talked a lot recently about how resilient, in aggregate, goods consumption has been, and the US GDP report showed that total consumption remains strong. The struggles of the freight industry is a good reminder that while the level of consumption remains high, there is a slowdown, and there is a lot of excess inventory in the system.

Here’s the punchline: even as cyclical sectors such as shipping get hit, big tech keeps growing. Back in September, we wrote that:

The long-term case for owning the very big tech companies (Facebook, Amazon, Microsoft, Apple and Google) is that you get a lot of upside and just a little downside. In an expansion, the monster techs use cheap capital to scale like mad. In a contraction, the boatloads of cash these companies spit out, a reflection of their strong competitive positions, provide a safe haven.

We felt a bit silly about holding this view a few months later when Big Tech stocks were taking a beating. And maybe we were wrong about what makes these stocks move. But on the operational level, the level of revenues and profit, the safe haven view of Big Tech is looking pretty good right now.

First Republic: who eats the ~$9bn?

Often, when a bank is in serious trouble, something gets done about it on a Friday afternoon, giving everyone involved the weekend to work out the details before the market opens on Monday. Well, today is Friday and First Republic is in serious trouble. So maybe something will happen this afternoon. So let us review, exactly, what details have to be worked out.

Here is First Republic’s balance sheet as of March 31:

This looks like a properly functioning bank’s balance sheet, but it isn’t, for two reasons. The debt liabilities — basically all owed to bits of the US government — are very expensive, likely rendering the bank unprofitable. Second, there are big mark-to-market losses in the securities and loan portfolios. First Republic’s most recent estimate of those losses, at the end of last year, was $27bn. The losses are probably a little smaller now because rates and spreads have moved around, but in the hypothetical balance sheet below I’ve taken all $27bn out, to render an estimate of the balance sheet in a sale or resolution:

To a first approximation, someone has to eat $9bn in losses, or maybe a bit less. It’s not going to be debt holders, which are the Fed and the Federal Home Loan Bank of San Francisco. They are secured creditors who hold collateral against their loans. The insured depositors are of course safe.

So it comes down to two classes of uninsured depositors: the 11 big banks who put in $30bn in emergency funds, and whoever else has, for reasons known only to themselves, left $20bn in uninsured money in First Republic. It is not clear at this point whether either class has priority over the other.

Some of you may be thinking that Treasury secretary Janet Yellen and the other authorities should just stick the magnificent 11 with the losses. They are big banks, who everyone hates, and First Republic is a banking industry problem. But as Steven Kelly of the Yale Program on Financial Stability pointed out to me, Yellen et al will need the goodwill of the big banks should some other bank or banks get into trouble. The easiest way to resolve a smallish bank’s troubles is to have a big bank or banks buy it, and let the problems “drown in the bigness”, in Kelly’s words. Regulators want to retain this option, so pissing off big bank CEOs is not optimal.

Indeed, some sort of arranged sale seems like the most likely resolution in this case. If a big bank or banks buy the loans and securities at above-market values, as has reportedly been proposed, they would take an accounting loss at the outset, but could match those assets against their own inexpensive funding, possibly achieving a positive spread, and then hope for rates to fall. It’s a fudge, not an ideal solution, but it would save the banks from taking outright losses on their deposits and save the authorities from doing another outright depositor bailout.

Credit squeeze or funding crunch?

Yesterday we argued that, despite much higher interest rates and a couple of bank failures, there are very few signs of a credit crunch out there. John Toohig, head of whole loan trading at Raymond James, wrote in to agree and added this commentary:

We trade loans for middle-market banks. The issue has not been credit. It’s very much still risk-on. However, funding those loans is the issue. Rising cost of deposits, having to borrow cash, compressed [net interest margin], that’s what is on their mind. At this higher cost of funds, how do I make my next loan? Mortgage issuance is going to be down when you double rates. Same thing with auto lending. The one shoe that hasn’t dropped yet are cap rates and debt yields on commercial real estate. The market is still somewhat upside down there trying to make sense of what’s going on. Only trophies and trash properties are trading. Valuations a bit hard to peg.

It feels like a slow credit squeeze, not a violent crunch, with real estate near frozen rather than collapsing. In a tweet linking to the newsletter, the good people at CrossBorder Capital argued that it’s not so much about rates as liquidity supply: “We have a ‘funding crunch’ and not (yet) a ‘credit crunch’. It shows [the] problem is a lack of liquidity rather than too high rates.” Whether the issue is rates or liquidity, we’re wondering what it will take to move the corporate economy from a mostly orderly credit-driven slowdown to something more violent and unpredictable.

One good read

Fancy a panic over CRE? This San Francisco office building is getting marked down 80 per cent.