More Tough News Out of the Retailers

Target’s earnings highlight frugality and deflation

Highlights

• Target’s earnings highlight frugality and deflation

• Hawkish tone in the FOMC minutes contrasts with weak economic data

• Challenging the “retiring boomers” thematic — can they drive growth?

• Tight credit spreads ignore rising bankruptcies

While We Were Sleeping

Dow futures are up just a smidge but we have nice gains in the S&P 500 and the Nasdaq ahead of the open as Nvidia’s across-the-board stellar results and upped guidance reverberates — carrying the AI boom to new heights (sending the share price above $1,000 — prompting the announced 10-for-1 stock split). European stocks have gained +0.6% while Asia again turned in a mixed performance: gains in Japan’s Nikkei 225 (+1.3%), India (+0.9%), Singapore (+0.4%), and Taiwan (+0.3%), but losses across Hong Kong (-1.7%), China’s Shanghai Composite (-1.3%), Thailand (-0.3%) and Korea (-0.1%). The word on the street is that China’s ballyhooed measures to ease the property sector crisis are far less than were needed to stem the ongoing erosion in real estate prices.

Hawkish “higher for longer” commentary from the FOMC minutes (and a revelation that some are still willing to raise rates — the release of the dot-plots at the June meeting will prove to be very interesting) and a solid set of preliminary May PMI data out of Europe have caused bond yields to head back up roughly +4 basis points across the Atlantic and by +2 basis points for the 10-year T-note rate to 4.44%. Perhaps a read of Target and Walmart Cut Prices as Inflation Hits Shoppers on page 9 of the FT will help contain the yield backup.

The DXY dollar index is off just a little, at 104.85, as it makes a test of the 50-day moving average on the upside. Spot gold is seeing a round of profit-taking, slipping -0.7% to $2,363 per ounce, and Brent crude is flat at $82 per barrel. Bitcoin is little changed at $69,497 (all market quotes are time-stamped to 4:15 a.m. ET). It is interesting to see how “a wave of speculation” is taking hold across the base metals (the FT’s words today, not mine — see Flurry of Fund Manager Bets Drives Metals to Record Highs on page 10) — the May global fund manager survey published by Bank of America showed a net 13% overweight in the commodity space, the highest exposure since April of last year and the increase in allocation over the prior three months was the biggest move since August 2020.

Speaking of those euro area PMI data for May, the service sector category hung in at 53.3, which is well into expansion mode while manufacturing turned less negative at 47.4 from 45.7 in April. Germany improved on both counts — to 53.9 from 53.2 for the services composite and to 45.4 from 42.5 for the manufacturing index. Improving economic momentum alongside an ECB rate cut should be tonic for Eurozone stocks, that is for sure. The competitively supercharged euro is good news for the large-cap industrials and the fact that the ECB is not being deterred by the German wage settlements in Q1, which rang in hot at +6.2% from +3.6% in the fourth quarter of last year, should also underpin the broad Consumer Discretionary group as well (as in Japan, the tourism industry on the continent is booming).

Back to that FT article on prices for a moment:

“Prices are dropping for thousands of items at Target and Walmart, as US retailers’ results indicate fatigue among some consumers after three years of high inflation.

Target this week said it would lower prices this summer for 5,000 items ranging from milk to paper towels in an effort to stay competitive. Walmart told analysts last week it had cut the prices of a large number of grocery products.

The cuts by two of the largest general merchandise chains illustrate how retail prices are levelling off, if not falling, after years of increases sustained by pandemic-era supply chain breakdowns and a sturdy US labour market.”

Page A9 of the WSJ also ran with an article underscoring how the U.S. labor market is showing a few more cracks — see Finding a Job Takes Longer for College Grads. A survey by the National Association of Colleges and Employers shows that new hiring for the Class of 2024 is going to shrink -5.8% from last year’s level. It is information like this that tells us that there likely is not enough Fed rate cuts priced in and anchors our sustained constructive interest-rate/bond-yield view.

And yet, those FOMC minutes were replete with inflation fear. The word “inflation” showed up more than 70 times! But what really caught our eye was this little ditty:

“Many participants commented that the public appeared to have a good understanding of the Committee's data-dependent approach in formulating monetary policy and its commitment to achieving its dual-mandate goals of maximum employment and price stability. Various participants also emphasized the importance of continuing to communicate this message.”

The Fed has told us that in no uncertain terms, policy is being determined by incoming government data that are constantly revised and either lagging or contemporaneous in nature. In my four decades in this business, I have never before seen any version of the Federal Reserve have its decisions influenced solely by backward-looking data. This puts the risk of a policy mistake much higher than commonly perceived — I see a Bloomberg poll that showed only 23% of investors believe a “recession” is the primary “tail risk,” while 59% believe in an “inflation resurgence.” I would be changing those two perceived odds around.

But that tone from the FOMC minutes was far stronger than the weak tone in yesterday’s housing market data, as they shifted the Fed funds futures contracts to now put 40% odds of no rate cut through September up from 27% last week. This reaction may prove to be overblown, mind you. Keep in mind that the last FOMC meeting took place prior to the recent wave of cooler-than-expected jobs and inflation data, not to mention the downgrades we are now seeing for Q2 real GDP growth estimates (and the strong likelihood that we will see a downward revision to the already-tepid +1.6% annualized growth rate for Q1).

One thing seems certain, which is that our “consumer frugality” theme is starting to play out very nicely — see As Consumers Pull Back, Target Aims at Basics on page B12 of the WSJ. Since inflation is ultimately determined by shifts in demand and supply, the implications for the former from consumers “pulling back” would seem to be more disinflationary than inflationary, even though that is clearly a minority opinion.

As we remain bond-bullish, a reminder that we are still long-term constructive on gold. The fabled “bond-bullion” barbell. No fervor. No speculation. And both provide a ballast in the portfolio with the S&P 500 and corporate credit spreads in their top 10% of valuations of all time. See New Gold Allure: It’s Sanctions-Proof, buried on page B12 of today’s WSJ. To wit:

“Gold is having its moment. Geopolitical hedging from global central banks could keep it shining.

Now at its highest level ever, around $2,400 per troy ounce, general jitters about the world alone can’t explain gold’s strength. The metal got a boost after the death of Iran’s president this week, but it has been on a tear over the past two years, appreciating 33% since the end of 2022.

The rally defies some typical headwinds. Prices surged this year even though real interest rates picked up: Yields on 10-year U.S. inflation-protected Treasury securities rose by around 0.37 percentage point in 2024. Gold typically moves in the opposite direction of real yields since it doesn’t generate any income and higher-real rates make it less attractive to hold.

And, notwithstanding trends like Americans buying gold bars at Costco, retail investment demand for gold hasn’t provided much support. Gold backed exchange—traded funds have seen net outflows for three consecutive years.

The big buyers behind gold’s rally? Global central banks, especially those in emerging markets. Central banks added around 2,200 tons of the metal since the third quarter of 2022, according to the World Gold Council—an increase of nearly $170 billion at current prices. Central bank net purchases account for more than a fifth of global gold demand or about twice the proportion between 2012 and 2021.

The likely trigger? Western sanctions on Russia after it invaded Ukraine in 2022 might prompted some central banks to diversify away from dollar-based assets. Russia’s roughly $300 billion in international reserves were frozen and there has even been talk of using the income on them to help defend or rebuild Ukraine. Featuring prominently in Russia’s reserves before and especially after the invasion: gold, which is easy to stockpile beyond foreigners’ reach.

Most gold buying from central banks isn’t reported, but among the purchases that have been, six central banks, including China, India and Turkey, have driven all the net buying since mid-2022, according to Goldman Sachs.

China’s central bank has been buying gold for 18 straight months since November 2022, boosting its gold reserves by 16%, or 10 million troy ounces. China’s economy is much larger and more important to the world than Russia’s was in 2022, which would make imposing sanctions tougher if it invaded Taiwan. A direct military conflict with the U.S. would be a different matter.

Clearly, China can’t move all of its $3.4 trillion in reserves into bullion, but increasing its exposure to gold could move the market quite significantly. Gold was approaching 5% of China’s total reserves as of April—a rise from around 3% in 2022. If China allocates just 1% more of its reserves into gold, that would be equal to around 9% of total global supply last year, using current prices.

Continuing geopolitical tensions between China and the West should keep gold bugs happy.”

I mentioned corporate bond spreads above. We have investment grade credit spreads at 87 basis points and below 300 basis points for the high yield market. Both are about half the historical norm and have only been here before in 2000 and 2007. The bull market narrative for equities is that they are trading off the “no cracks” message from the credit market but this looks to be a case of the blind leading the blind. A bubble in one asset class being priced off the bubble in the other. At current spread levels, the market for corporate bonds is indeed signaling a no-default future. Yet, we see with our own eyes that corporate bankruptcies have risen +35% over the past year (see more below) and the default rate has ticked up to 5.8% for junk-bond issuers over the twelve months through March, its highest level in three years (Moody’s data). The thing is, high yield spreads were sitting some +40 basis points wider back then compared to today.

Another day, another retailer disappointment — this time courtesy of Target, in the latest sign of frugality taking hold. The stock plunged by -8% in its biggest daily decline since November 2022 as comparable sales in Q1 fell by -3.7% YoY, extending the string of negative prints to four straight quarters. Weakness was driven by both a falloff in traffic (-1.9%) and pricing (-1.9%) as goods deflation continues to filter through the economy. Profits shrunk by -1% in the first quarterly miss on this basis in the past six quarters. Customers are clearly shoring up budgets and only spending when they have to, as general merchandise sales went in reverse. Of utmost concern, even purchases of groceries declined in the quarter (is everyone going to Walmart and Costco instead?).

Making matters worse was a disappointing set of guidance, with management seemingly not confident that a durable turn in activity is at hand — full-year same-store sales are projected to be “flat to up +2%” compared to prior guidance of a “modest increase” with Chief Growth Officer Christina Hennington stating “we remain cautious on the near-term growth outlook.” Read on for some more key quotes:

“This normalization [of spending patterns], combined with the cumulative impact of higher prices on consumer budgets is resulting in continued soft trends in discretionary categories, most notably in-home and hardlines.”

“[…] we announced that we've made price cuts on 1,500 frequently shopped items in many markets and we're planning additional price cuts on 1,000 more items this summer.”

“Currently, one in three Americans has maxed out or is nearing the limit on at least one of their credit cards. For these reasons and more, we remain cautious in our near-term growth outlook. Notably, we expect discretionary trends will continue to remain pressured in the short-term, but to normalize over-time.”

A Bifurcated Economy

First, regarding the consumer, volume spending growth on goods has become saturated, and the trend is quickly heading to zero. For sure, service sector spending has held up, but keep in mind that one-third of all consumer expenditures are accounted for by health care services and shelter, which rarely, if ever, decline, even in the worst recessions. Second, while the CHIPS subsidies have ignited solid growth in non-residential construction, business spending on machinery and equipment, both tech and non-tech, is virtually stagnant.