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Despite 2022 successes, underperformance rates are ‘abysmal’ for active large-cap managers since 2008

The S&P 500 may be trading around 2022 lows, but a new report finds active managers are having their best year since 2009. The numbers suggest they still have a long way to go, though.

S&P Global recently published its Mid-Year 2022 SPIVA U.S. Scorecard, which measures how well U.S. actively managed funds perform against certain benchmarks. The study found that 51% of large-cap domestic equity funds performed worse than the S&P 500 in the first half of 2022, on track for its best rate in 13 years — down from an 85% underperformance rate last year.

 

This is partially due to the declining market, said Anu Ganti, senior director of index investment strategy at S&P Dow Jones Indices. Ganti told CNBC’s Bob Pisani on “ETF Edge” this week that losses across stocks and fixed income, as well as rising risks and inflation, have made active management skills more valuable this year.

Despite the promising numbers, long-term underperformance remains, as Pisani noted, “abysmal.” After five years, the percentage of large caps underperforming benchmarks is 84%, and this grows to 90% and 95% after 10 and 20 years respectively.

The first half of the year was also disappointing for growth managers, as 79%, 84% and 89% of large-, small- and mid-cap growth categories, respectively, underperformed.

Underperformance rates

Ganti said underperformance rates remain high because active managers historically have had higher costs than passive managers. Because stocks are not normally distributed, active portfolios are often hindered by the dominant winners in equity markets.

Additionally, managers compete against each other, which makes it much harder to generate alpha — in the 1960s, active managers had an information edge since the market was dominated by retail investors, but today, active managers primarily compete against professional managers. Other factors include the sheer frequency of trades and the unpredictability of the future.

 

“When we talk about fees, that can work against performance, but it sure helps by putting feet on the ground and putting up a bunch of ads all over the place where you may not see that as much in ETFs,” said Tom Lydon, vice chairman of VettaFi.

Lydon added that there are not enough ETFs in 401(k) plans, which is where a lot of active managers are — 75 cents of every dollar going into Fidelity funds goes in via 401(k) plans. The 401(k) business is dominated by people who make money from large trades, in contrast to low-cost ETFs that don’t make much. With $400 billion in new assets coming into ETFs this year and $120 billion coming out of mutual funds, it may take a long time until those lines cross.

“We’re going to have one of those years where equity markets may be down, fixed income markets may be down, and active managers may have to go into low cost basis stock to sell them to meet redemptions, which is going to create year-end capital gains distributions,” Lydon said. “You don’t want, in a year where you’ve been the one to hang out, to get a year-end present that’s unexpected and unwanted.”

‘Survivorship bias’

Another component of the study is the “survivorship bias,” in which losing funds that are merged or liquidated don’t show up in indexes, and thus the rate of survivorship is skewed. The study accounted for the entire opportunity set, including these failed funds, to account for this bias.

Thus, Lydon said, amid periods of market pullback, investors should adopt a longer-term outlook and try not to be a “stock jockey,” since the best manager today may not be the best in the long run.

Low-Beta Stocks Shield Investors From Volatility

Volatility has headlined the market following the Fed’s Jackson Hole Economic Symposium. Fed Chairman, Jerome Powell, was rather hawkish in his comments.

Powell believes bringing inflation down will take some time, adding that the plan will, unfortunately, “bring some pain to households and businesses.”

Needless to say, the market didn’t react well to the comments, as they essentially crushed any hopes that the Fed would soon reverse its rate-hike trajectory.

Pairing these remarks with the fact that we’re about to break into September, a historically weak month in the market, gives investors plenty of valid reasons to consider a defense-first approach.

 

For investors looking to shield themselves against volatility, stocks that carry low betas would provide precisely that.

Stocks with a beta of less than 1.0 are less volatile than the general market, and those with a beta of higher than 1.0 are more volatile than the general market.

Three companies that carry a beta of less than 1.0 include H&R Block HRB, Kellogg Company K, and American Electric Power Company AEP.

Below is a chart illustrating the year-to-date share performance of all three companies with the S&P 500 blended in as a benchmark.

Zacks Investment Research
 
Let’s take a closer look at both companies:

H&R Block

H&R Block HRB is the world’s largest income tax filing company, offering income tax return filing services for salaried individuals via three distinct methods: free online e-filing, assisted tax e-filing, and in-person tax e-filing.

The company carries a beta of 0.69.

In addition, H&R Block’s forward earnings multiple resides at a nice 12.2X, representing a steep 42% discount relative to its Consumer Discretionary Sector. The company carries a Style Score of an A for Value.

Zacks Investment Research
 

HRB has been on an impressive earnings streak, exceeding the Consensus EPS Estimate in six consecutive quarters. Top-line results have also been robust, with H&R block chaining together ten straight revenue beats.

Below is a chart illustrating the company’s revenue on a quarterly basis.

Zacks Investment Research
 

Furthermore, the company rewards its shareholders via its annual dividend yielding 2.3%, much higher than its Consumer Discretionary Sector average of 0.9%.

H&R Block has upped its dividend payout four times over the last five years, undoubtedly a major positive.

Zacks Investment Research
Zacks Investment Research

Kellogg Company

Kellogg Company K manufactures and markets ready-to-eat convenience foods, with a balanced portfolio of cereal and snack products.

Kellogg Company carries a beta of 0.43.

The company’s shares trade at solid valuation multiples, further displayed by its Style Score of a B for Value. K’s forward earnings multiple resides at 17.9X, representing a sizable 12% discount relative to its Consumer Staples Sector.

Zacks Investment Research

In addition, Kellogg’s has consistently exceeded quarterly estimates – the company has surpassed bottom and top-line estimates in nine of its previous ten quarters.

Kellogg’s dividend metrics also deserve a highlight – the company’s annual dividend yields a sizable 3.1%, much higher than its Zacks Consumer Staples Sector average of an already steep 2.6%.

Furthermore, the company has upped its dividend payout five times over the last five years.

Zacks Investment Research
 
Is Apple a Buy ahead of (inflationary) iPhone 14 release ?

Apple stock is up over 15% in the last two months as investors bank on higher prices for the iPhone 14 family and speculate on new augmented reality glasses from the tech giant.

  • Price Target: $185

  • Rating: Buy (reiterated)

  • Stock Price movement assumed: +16%

 

Call on iPhone pricing:

In our Apple model we assume iPhone 14 is launched at the same launch prices as iPhone 13, . However, with an inflationary backdrop, Apple could choose to increase the price of the Pro models (high end consumer less sensitive to price) and leave the lower end models unchanged.

If Apple were to raise pro-model prices by $50,”  , “we estimate a $0.20 EPS tailwind. We look at a scenario where Apple raises iPhone 14 Pro/Pro Max prices by $50 each, while lowering prices for iPhone 14/14 Max by $50. We estimate about $0.10 benefit if 10 million incremental iPhone units are sold.

Apple has launched a new version of the iPhone around the start of its fiscal year for the past 14 years. The stock has seen double-digit growth for many of those years and even saw triple-digit growth in fiscal year 2020.

Bring on the new iPhone, says Apple investors.
 
Bring on the new iPhone, says Apple investors. (Chart: BofA)
Long-term thesis on Apple:

Our Buy rating on Apple is based on a number of factors: “1) strong iPhone upgrade cycle in fiscal year 2023 driven by the need for higher connectivity which will enable new AR/VR applications, 2) higher growth in services revenues, 3) expectation that the multiple will re-rate higher as has been the case before major product launches, 4) continuing strong capital returns, 5) Apple likely to charge for App and in-App purchases outside the App store, and 6) shares likely to outperform in a broader market down cycle.”

Tech industry update:

Second-quarter earnings season for a large chunk of large-cap tech companies has been mixed, at best.

Companies such as HP have warned about slowing growth in PCs as consumers pull back on spending.

Meanwhile, Salesforce recently warned about cooling sales for enterprise clients. And companies like Snap are laying off workers in droves to combat a slowdown in the advertising market.

From the Yahoo Finance Live archives: HP CEO Enrique Lores weighs in on demand for PCs

“So this is something that we were expecting, a slowdown in consumer, but clearly the slowdown was bigger than we were expecting,” HP CEO Enrique Lores told Yahoo Finance Live following a sales miss late Tuesday.

Overextended Chinese Real Estate Sector Is A Systemic Problem
  • At the heart of this credit-deterioration process is the way in which the form and structure of economy activity in China has evolved over the past ten to twenty years.
  • Another process is also important for understanding the stresses on the Chinese banking system, namely the way households, businesses, and financial institutions began systematically taking too much financial risk onto their balance sheets.
  • Among the key lessons from the history of these Minskyite processes is that analysts, even those who have correctly identified the relevant balance sheet distortions, almost always underestimate the adjustment costs when conditions correct.

In the first half of this two-part blog post, I discussed the problems affecting four rural banks in Henan and the subsequent mortgage boycott in parts of China.

In the second half, I argue that these crises need to be seen not as isolated events but rather as signs of systemic problems that reveal a great deal about China’s finances and balance sheet.

After discussing the troubled rural banks in Henan in my previous post, it is important to note that what happened in Henan was not the first adverse credit event to hit the Chinese financial system.

It was just the most recent in the country’s latest string of notable financial events, which can be said to have started back in May 2019 with the intervention in Baoshang Bank. A little over a year later, Baoshang became the first Chinese bank to be shut down since Shantou Commercial Bank closed shop in 2001.

The Baoshang case was followed by interventions or investigations involving several other institutions, including banks, shadow banks, property developers, local governments, homebuyers, and other overextended borrowers.

Because these events seem to be happening regularly, and with rising breadth and magnitude, it should be clear that they are not isolated events that can be blamed on the various triggers that set them off. They are far more likely to be part of a systemic problem that has been brewing in China’s economy for more than a decade.

This means, among other things, that even if the property market recovers next year as a consequence of the end of pandemic lockdowns, the recovery can only be partial and temporary. In the medium term, property prices will continue to decline, and insolvencies will keep on emerging. Until the systemic problem is addressed and resolved, there can be no permanent stabilization of China’s property market or of its economy more generally.

China’s Financial Deterioration

At the heart of this credit-deterioration process is the way in which the form and structure of economy activity in China has evolved over the past ten to twenty years. In most countries, GDP is a measure of the output delivered by economic actors over a specified period, whereas in China GDP is an input determined politically at the beginning of a time period.

Once China sets its GDP target, local governments (and, until recently, the property sector) have had the responsibility of delivering enough economic activity to bridge the gap between the GDP growth target and what Beijing usually calls “high-quality growth” – that is, the underlying growth rate delivered by the private economy, consisting mainly of consumption, exports, and business investment.

Bridging the gap between the two was not a problem for the Chinese economy during the first thirty years of the period known as reform and opening up (the late 1970s until the late 2000s), mainly because China was seriously underinvested in property, infrastructure, and manufacturing capacity, so the investment that the GDP growth target required was, for the most part, productive.

It is probably not a coincidence that during these years China’s GDP growth almost always exceeded the growth target, sometimes by a few percentage points.

This began to change ten to fifteen years ago, by which time China had largely closed the gap between the investment it had and the investment that the economy could productively absorb.

When that happened, China should have dramatically lowered the share of production it reinvested, but to do so without causing a sharp drop in the growth of economic activity required rebalancing the economy toward greater consumption, which in turn meant transferring income from previously successful parts of the economy to the household sector.

This has always been the hardest part of rebalancing (as I discuss here). China, like other countries that have followed this model, found itself politically and institutionally unable to manage the transfers.

It did, however, keep investment growth rates high and – again, like nearly every other country that has followed this model – China began to overinvest systematically in projects that contributed less to the economy than they cost.

The result was a sharp increase in the country’s debt burden: it is only when debt is used to fund nonproductive investment that debt rises faster than a country’s debt-servicing capacity, for which GDP is a proxy.

The Chinese financial system is wholly dominated by banks, and the credit allocation decisions among the banks are effectively determined administratively, largely through various forms of “window guidance” by the People’s Bank of China, the State Council, and/or local governments. Because of that, the rise in debt was most likely to occur either on the balance sheets of the banks or on those of entities supported by the banks.

This state of affairs also meant that the country’s financial system had to be underpinned by implicit moral hazard. This is because while the rise in debt on the banks’ balance sheets was naturally matched by a rise in the book value of assets, the real economic value of these assets was often far less than the book value, so what looked like healthy balance sheets were in fact often seriously strained and had embedded hidden losses. Banks and bank investors would only accept this condition if they believed that the government would make these losses whole.

By combining excessively high GDP growth targets with an administratively determined credit allocation process (rather than a market-determined one), China consequently ended up with a financial system underpinned by moral hazard.

As a result, once the country ran out of easy investment opportunities, it was inevitable that there would be rising stress within the banking system and a rising risk of insolvency.

All of these issues were exacerbated by the way conditions developed in China’s real estate sector, which in many ways was a mirror of infrastructure spending. Like infrastructure spending, the property sector absorbed a sizable share (roughly 25 to 30 percent) of China’s extraordinarily high investment rate (with investment accounting for roughly 40 to 45 percent of Chinese GDP).

As such, the property sector is one of the two main engines that has allowed Beijing to achieve its growth targets, but it has required surging amounts of debt, which rapidly have exceeded the value of the associated projects, and this arrangement has depended for many years on an implicit guarantee (in this case, through ever-rising property prices) that allowed developers a free hand to exploit leverage.

Balance Sheet Inversion

Another process is also important for understanding the stresses on the Chinese banking system, namely the way households, businesses, and financial institutions began systematically taking too much financial risk onto their balance sheets. This is a point whose extent and importance seems to elude most economists, although it is one that Hyman Minsky often made.

Any economy usually has a normal distribution of risk-taking behavior among businesses, households, and financial institutions. Normally entities that take too little risk underperform and eventually get squeezed out of the market, while those that take too much risk overperform at first, but then eventually run into trouble during corrections. This is how a well-functioning market effectively polices risk-taking.

But economic actors will learn to game anything that an economic system rewards. The problem occurs when an economy undergoes many years – even decades, in China’s case – of rapid growth, expanding liquidity, and soaring real estate and asset prices. Under such circumstances, entities that tend to take on too much risk are never disciplined, and year after year they systematically outperform those that take on more prudent levels of risk.

In such a system, as Minsky explained, over time households, businesses, and banks are all forced to take on the same risky structures if they are not to fall behind their competitors. This creates two types of risks.

  • Individual risk: Households and businesses take on excessive leverage and mismatch their balance sheets. This means that each entity responds to external conditions in ways that make it individually more prone to breaking down when certain conditions change or are reversed.
  • Systemic risk: The ways in which households and businesses take on excessive leverage and mismatch their balance sheets are aligned and highly correlated. This alignment is very important because it means that bankruptcies and balance-sheet breakdowns do not occur individually and randomly over time, but rather occur in coordinated waves among a wide range of entities simultaneously.

When the forms of excessive risk-taking are highly correlated across a large number and wide variety of entities, this causes systemic risk, or the risk of a breakdown in the overall financial system, to surge. This is why Minsky considered the correlation among balance sheets to be more important to the overall economy and financial system than the riskiness of individual balance sheets.

Broadly speaking, there are three interrelated components that drive a country’s financial and economic system toward the kind of systematic instability that Minsky warned about. These are financial distortions in economic actors’ operations, warped balance sheets, and an exacerbated wealth effect.

  • Financial distortions embedded in operations: Households and businesses adapt their behavior to their operating environments in such a way that conditions or distortions that have characterized the economy for many years become embedded in the operations of these actors.
  • Financial distortions embedded in balance sheets: In parallel, financial conditions that have been maintained for many years become embedded in households’ and businesses’ balance sheets. This is part of what Minsky meant when he famously observed that financial stability is itself destabilizing. After many years of stable or improving exchange rates, monetary consistency, declining inflation, rising collateral values, and/or expanding liquidity, financial institutions begin to structure increasingly risky financial activity that implicitly or explicitly assumes away these risks.
  • The wealth effect: When asset prices rise faster than growth in the underlying economy, it creates perceptions of wealth that are often fictitious and temporary (what John Kenneth Galbraith referred to as “bezzle”). This fictitious wealth, however, has a pro-cyclical economic impact, boosting spending further during the good times, as it is being seemingly created, and repressing spending during the bad times, as it is being (so to speak) destroyed.

Notably, while some of these distortions are consequences of policy decisions, others are natural and automatic consequences of many years of a particular set of growth conditions. Households and businesses adapt their behavior to their operating environments, so conditions that have been maintained over many years become embedded in their operations and balance sheets.

Households’ And Businesses’ Operating Environments

It may help to take in turn each of the three components (with concrete examples) that drive a country’s financial and economic system toward the kind of systematic instability China is experiencing. To take the first, the real estate sector offers the most easy-to-see signs of how several years of economic and financial expansion distorts the operations and balance sheets of households and businesses.

When property prices seem only to rise year after year, businesses that overinvest in real estate relative to their operational needs outperform and eventually displace those that don’t, while the banks that lend directly or indirectly against real estate tolerate excessively risky loans on the assumption that their risks will be mitigated by continually rising prices.

This happened in China. In the 1980s, under Deng Xiaoping’s leadership, China underwent a successful series of liberalizing reforms that unleashed the country’s productive capacity. As capital poured into investment projects, Chinese growth levels soared almost immediately and stayed high throughout the 1980s and 1990s.

As China became more urbanized and as its businesses grew more productive, real estate prices began to rise. This was a natural and necessary development. As long as real estate prices reflect fundamental demand for current use, rising real estate prices perform an important economic function in a market economy. They calibrate demand and supply, thereby allocating land to the businesses that will use it most productively.

But, in China’s case, as real estate prices rose year after year, it changed businesses’ behavior in ways that in turn distorted prices. In any given economy, competing businesses normally include a range of risk appetites from the very prudent to the very adventurous.

After a period of rising prices, at some point businesses with higher risk appetites and a more optimistic outlook will begin to anticipate their future real estate needs.

On the assumption that property prices will continue to rise indefinitely, they buy more land than they operationally require, effectively speculating on future price increases. (Notably, in an environment of ever-rising prices, this form of speculation is often praised as foresight.)

In such circumstances, the most successful businesses are often not the ones that are most successful at producing and marketing products, but rather the ones that were most aggressive in speculating on real estate.

As real estate prices continue to rise, businesses that are willing to take excessive property risk consistently outperform their more prudent rivals, and over time the former begin to displace the latter.

Over time, real estate purchasing switches from being largely driven by fundamentals, based on the operational needs of the business at the time of purchase, to at least partly speculative and eventually largely speculative.

This gradual and pro-cyclical transformation of the market probably began to occur in China in the 1990s, a shift that had two important and seemingly contrary effects.

First, the boost in demand generated by speculative purchasing caused prices to rise faster than they otherwise would have, thus undermining the economic function of prices in the efficient allocation of land. The pricing mechanism, rather than selecting for the most productive users of land, began to favor those willing to speculate.

At first glance, one might expect the consequences of this trend to be self-correcting. Property in China soared, becoming significantly more expensive relative to GDP compared to property in the United States and Europe. These extreme price distortions should lead to a suboptimal allocation of resources, which in turn should lead to weaker growth, and this in turn should depress expectations and reverse the price distortions.

Over the medium term, however, the tendency to self-correction can be overwhelmed by the second of the two effects. Real estate prices can rise rapidly for years, and as they do, because the mingling of speculative profits and operating profits cannot be easily disentangled, speculative profits inevitably begin to show up as a higher value-added component of GDP growth, as wealth effects boost spending even further.

Over time, in other words, GDP growth is artificially boosted by soaring real estate prices and speculative real estate development, which in turn are boosted by high GDP growth expectations, with each element reinforcing the other.

Although I have used the example of real estate here to illustrate this Minskyite process in which long-term market conditions can become embedded in business operations, this self-reinforcing intermingling of operational and speculative activity occurs not just with real estate.

If GDP growth rates are high for many years, to take another example, and businesses expect that policymakers will stimulate aggressively to prevent growth from declining, those that use leverage to accumulate market share tend to outperform and eventually displace those that don’t. In such cases, overall business leverage must rise.

If the central bank guarantees liquidity and represses interest rates, to take yet another example, the cost of maintaining high inventory levels declines and businesses adapt by maintaining production levels regardless of changes in demand.

If businesses come to expect a stable and undervalued currency, to take still another example, the export sectors effectively bet on currency stability and exports expand relative to imports and domestic demand.

The point is that businesses adapt to the conditions around them, and when a set of extreme conditions remain in place for long periods of time, they begin to incorporate these conditions into their expectations and thus into their operations.

They do so not as a policy but because of a sorting mechanism that automatically rewards certain types of risky behavior. In such circumstances, businesses are rewarded for individual behavior that collectively makes the system riskier, and they are penalized with consistent underperformance relative to their peers if they do not participate in this behavior.

As a result, businesses collectively build up overreliance on a certain set of conditions in such a way that, when these conditions change, there is much less resilience.

Households’ And Businesses’ Balance Sheets

The second of the three interrelated components listed above relates to how households, businesses, and financial institutions design their balance sheets. As they respond to a particular set of assumptions, these assumptions become embedded in how liabilities are structured on their balance sheets.

As more and more entities begin to align their liabilities in the same way, this increases balance sheet susceptibility to the risk that the assumption will eventually be reversed.

Over a long period of expanding liquidity, for example, households, businesses, and financial institutions learn to undervalue liquidity, in which case there is a tendency to reduce borrowing costs by shortening maturities on the liability side of the balance sheet relative to the asset side, or otherwise mismatching the two sides of the entity’s balance sheet.

Businesses that fund long-term investment with shorter-term borrowing consistently outperform their more prudent rivals, especially if many years of rapid growth also cause credit spreads to drop. In such cases, riskier borrowers benefit from short-term borrowing not just from lower liquidity premia but also from declining credit spreads.

The problem that especially concerned Minsky – besides the obvious problem that lenders and borrowers are willing to engage in increasingly risky behavior on the assumption that they can ignore certain types of risk – is that as a growing share of the economy’s balance sheets become aligned in this way, the implicit value of liquidity actually rises, in such a way that each degree of mismatch becomes increasingly risky even as the amount of mismatching also rises.

In other words, as more and more businesses effectively short liquidity by taking on illiquid balance sheet positions, they reduce the amount of liquidity in the operating part of the economy.

That is why when a liquidity shock does occur, as it eventually must, the consequences can be so painful and unexpected. As households, businesses, and financial institutions rush to convert their risky assets into cash and other liquid instruments, the price of these risky assets tends to fall and the value of liquidity tends to rise.

As that happens, the entities can be caught in a squeeze in which asset values and revenues fall even as financing costs rise – until the central bank is forced to step in to absorb the liquidity mismatches of the economy.

There are many other kinds of financial conditions that become incorporated into balance sheets. With the perception of ever-rising prices for real estate or other asset classes, to take another example, banks and other lenders tend to become overly aggressive in lending against collateral.

As was the case in China, banks may collude with borrowers to overstate land values in order to expand (seemingly risk-free) collateral-based lending as rapidly as possible.

The point, again, is that this is an automatic process, and it leads to balance sheets that are not only increasingly mismatched but, more importantly, mismatched in the same way across the economy.

Households, businesses, and financial institutions don’t simply decide individually at some point to take on excessive levels of risk. They do so gradually and collectively because of operating and financial conditions that encourage them to adopt such behavior and that penalize (with consistent underperformance) those that do not do so.

An Exacerbated Wealth Effect

The third of the three interrelated components that drive a country’s financial and economic system toward the kind of systematic instability that Minsky warned about is the way these conditions create a pro-cyclical wealth effect.

I discuss how this works in much greater detail in an August 2021 blog entry, but the key point can be summarized briefly. Long periods of rapid growth are associated with a kind of financial exuberance that almost always leads to overvalued asset prices, usually including real estate prices and often including infrastructure, excess inventory, and other assets.

By making businesses and homeowners feel richer, surging real estate and asset prices can reinforce this rapid growth and financial exuberance by encouraging them to spend more money than they otherwise would have. This tendency is called the wealth effect.

As perceptions of rising wealth justify decisions by homeowners and businesses to spend more money than they otherwise would have, the additional spending boosts income elsewhere in the economy, thus reinforcing the rapid growth and financial exuberance.

Unfortunately, the wealth effect works in both directions, although it usually works much more brutally on the way down than on the way up. When financial exuberance is reversed and overvalued asset prices begin to correct, businesses and homeowners begin to see a decline in their recorded wealth, and the negative wealth effect causes them to cut back sharply on spending just as the economy is already slowing.

This, needless to say, exacerbates the slowdown, which in turn can cause a wide variety of asset prices to fall even more quickly. Signs of this have already started to appear in China beginning with last year’s clampdown on the property sector.

The Problem Is Systemic, Not Trigger Specific

Four important points stand out. First, to paraphrase Minsky’s mantra that stability is destabilizing, when households, businesses, and financial institutions increasingly embed assumptions about the stability of various parts of the economy in their operations and balance sheets, the very act of doing so increases the riskiness of the financial system and eventually begins to undermine those assumptions.

Second, when instability occurs, people naturally tend to assume that the problem was one of stupidity or fraudulent behavior or even a product of recent policy decisions.

In fact, while there is often plenty of unethical behavior – good times, as Walter Bagehot pointed out 150 years ago, breed fraud – stupidity, fraud, and policy changes are not needed to explain the emerging instability.

The problem is that over many years most rational players have been incentivized to shift their behavior in response to a set of stabilizing distortions in such a way that any reversal of these distortions can become very painful and costly.

The most extreme cases of this behavior are usually the first to fall, thus reinforcing the idea that the instability is caused by individual cases of fraud and stupidity, but in fact the problem is general.

Third, this is almost by definition a systemic problem. In China’s case, three decades of rising property prices, expanding liquidity, moral hazard, and high levels of property and infrastructure investment were economy-wide conditions.

It would have been truly surprising if Chinese households, businesses, and financial institutions did not respond to decades of these extreme conditions without incorporating them into their operational and financial assumptions.

As Minsky would have explained, it’s not just that lots of individual balance sheets have incorporated too much risk. The underlying issue is that they have incorporated too much risk in a similar manner, so any adjustment or shock affects much of the economy at the same time and in the same way.

Fourth, these are obviously not just China-related problems but rather problems that have affected and will continue to affect many financial systems around the world and throughout history.

These risks have been especially prevalent in China over the past few years because of the highly unusual and highly coordinated historical circumstances of Chinese growth, but they are risks that should be understood in principle in a wide variety of contexts.

Self-Reinforcing Behavior

Among the key lessons from the history of these Minskyite processes is that analysts, even those who have correctly identified the relevant balance sheet distortions, almost always underestimate the adjustment costs when conditions correct.

This is probably because they fail to consider the many self-reinforcing processes embedded in the balance sheets and operations of economies that have gone through this process.

This is especially likely to be the case with China. One of the most powerful of these feedback loops, for example, has involved the behavior of local governments, and it has become, not surprisingly, among the most disruptive processes in the current economic malaise.

In China’s case, the relevant feedback loop went from rising property prices, to rising property development and rising government revenues, to rising government expenditures on infrastructure and services, to rising growth expectations generated by property development and government spending, and (by virtue of these rising expectations) back to further rising property prices.

Reversing any part of this loop risked setting the whole process in reverse in a way that resulted in an opposite self-reinforcing process of declining property prices, slower growth, and reduced government expenditures.

Even the way in which Chinese mortgages evolved represents an example of this feedback process. As I discussed in part one of this two-part blog post, in China, to a much greater extent than in most other economies, it is possible to take out mortgages against property that hasn’t been built yet.

This is good for the developers in a rising market. Wang Yongli, a former deputy governor of the Bank of China, explained this well in a recent article translated by Wang Zichen:

Under this arrangement, buyers actually provide a large amount of interest-free funds for the developers (establishing a form of entrusted agent construction), which greatly reduced the capital cost and financial risk of the developers, and provided a source of income for banks (the interest of the mortgages) and government (real-estate related revenue).

As long as it is assumed that property prices can only rise, taking out mortgages against nonexistent homes makes sense for everyone. The problem, Wang explains, is that this arrangement creates incentives for property builders to engage in behavior that is highly pro-cyclical, and these incentives become stronger just as conditions change:

As a result, developers will take all possible measures to expand the pre-sale of apartments. They then use the money to expand their business, such as purchasing more land, slowing down the construction of the apartments that have been paid for to take more advantage of the interest-free funds, or even cutting corners on the building quality and their supporting facilities. Once the developers cannot deliver the apartments on time or with good quality according to the contract, the scattered and (structurally) weak buyers can hardly protect their own rights and interests.

What was good for developers in a rising market turned out to be (not surprisingly) bad for developers in a falling market. As homebuyers became increasingly worried about the risks associated with pre-sales, this triggered behavior that cut off funding for property developers at the worst possible time, and this behavior in turn exacerbated declining prices as well as liquidity and solvency problems among property developers.

The pre-sales crisis may have been an idiosyncratic Chinese type of trigger, but again it is important to stress that, while the specific forms in which the various feedback loops are triggered may differ in unpredictable ways, they nonetheless must emerge for systemic reasons during a long period of surging property pieces and expanding liquidity.

It is easy to confuse triggers with causes, but if these feedback loops don’t emerge in one form, they will emerge in another. Analysts will spend a lot of time and effort discussing the sources and consequences of specific triggers and what might have been done to divert them, but these triggers are simply symptoms of an underlying systemic problem. They are not the underlying problem.

There are many other similar feedback processes affecting the Chinese property sector and, more generally, the economy, including the high share of household savings held in property, the pro-cyclical nature of sectors that account for disproportionately large shares of the economy (like the property and infrastructure sectors), the systemic impact of fictitious wealth, extensive moral hazard, and so on.

Because these feedback loops emerge in ways that reinforce growth during periods of expansion, this often makes it hard to tell the difference between the underlying growth processes driving the economy and the additional growth created mainly by self-reinforcing processes embedded in balance sheets and business operations.

One result of this confusion is that before the reversal is triggered, analysts and policymakers often assume the underlying growth dynamics of the economy are greater than they really are. This often leads them to overestimate the sustainable growth rate of the economy during the expansion period.

Financial Contagion

Chinese authorities have fortunately racked up a great deal of experience in managing the spread of financial contagion. They understood the contagion risks and reacted quickly to create the necessary liquidity to prevent things from spiraling out of control. A July 2021 Bloomberg article listed some of their responses:

The China Banking and Insurance Regulatory Commission… issued guidance in response to the boycotts aiming to expedite the delivery of homes to buyers, a newspaper published by the commission reported Sunday, citing an unidentified senior official at the agency. China is responding to protests that flared up at 100 housing projects across 50 cities, threatening to spread the real estate crisis to the banking system. Regulators met with banks last week to discuss the boycotts, while state media cited analysts warning that the stability of the financial system could be hurt if more homebuyers follow suit.

The city of Zhengzhou responded by announcing the establishment of a bailout fund to take over and complete these unfinished projects. According to a recent South China Morning Post article:

Henan’s local authorities assigned a bad-loans manager and a state-owned real estate developer to clean up the province’s property mess, taking drastic action to contain a crisis ahead of China’s twice-a-decade leadership conclave. A working team set up by Henan Asset Management Company and Zhengzhou Real Estate Group will help cash-starved developers to work out their funding woes, according to a report posted on the asset management firm’s website. The team will also aim to revive stalled projects, sell assets and restructure businesses to ensure the completion and smooth delivery of homes to contracted buyers, the report added.

In addition, the authorities forced some of the weaker banks to shore up their capital bases. To quote another Bloomberg article:

The central government will allow 320 billion yuan generated from the sale of special local bonds to be used to top up the capital of medium- and small-sized banks, the Financial News reported last week, citing an unnamed official with the China Banking and Insurance Regulatory Commission. The amount, including 120 billion yuan in unused funds from last year, is 60% higher than in 2020 when money from the sale of these bonds was first allowed to be used for that purpose.

On July 28, 2021, the Politburo, China’s top policy-making body, “pledged to stabilize the property market,” according to the Wall Street Journal. The Politburo “said it would work to resolve problems in the rural banking system but it said local governments should take direct responsibility for delivering unfinished homes and supporting demand for housing.” The article continues:

Local governments have rolled out a flurry of incentives in recent weeks to boost their property markets, including tax rebates, cash rewards and lower down payments. Zhangshu, a city of roughly 500,000 people in the eastern Chinese province of Jiangxi, is offering the equivalent of about $150 to property brokers who can make a sale. Guyuan, a city of 1.5 million in China’s northwest, has offered to subsidize 1% of purchases for first-time home buyers. In Chizhou, in China’s rural interior, potential home buyers can attend a government-run real estate fair, buy a home, receive 3,000 yuan of subsidy worth about $450, have their down payment reduced to 20% from 30% and have some of their property management fees waived.

Meanwhile, the People’s Bank of China announced that it would issue 200 billion renminbi of low-interest loans for banks to supplement with their own funding to help “fill the funding gap needed to complete unfinished projects.” Other steps have been taken, too, and there are likely to be more moves announced over the next few days and weeks.

These rapid reactions to stem the spread of financial contagion show that Beijing clearly recognizes that the problem is systemic, not specific to a few badly managed banks.

This view was reinforced when, soon thereafter, Liang Tao, vice chairman of the China Banking and Insurance Regulatory Commission, reportedly warned of “high hidden risks” in the shadow finance sector, “as some products have complex structure and high leverage levels.” According to Reuters, he went on to insist on vigilance toward “a rebound of shadow banking risks as some institutions may use improper financial innovations to create new variants of shadow banking.”

What Will Happen Next?

But while Beijing reacted quickly to these events, it is nonetheless important to recognize that the various solutions proposed mainly involve resolving liquidity concerns. They do not address the more fundamental solvency concerns.

Extending or guaranteeing liabilities simply extends the period during which insolvency can be resolved, whereas resolving insolvency, or other forms of bad debt, means above all allocating the losses to one or another specific sector of the economy.

That is not what has happened in China. The various solutions and proposed solutions have merely transferred the problem from the local banks onto either local governments’ balance sheets or – to the extent that smaller bad banks are to be merged with larger, healthier banks – onto the balance sheets of larger banks. The regulators, in other words, are addressing what is basically an insolvency problem by extending or insuring liabilities as if it were a liquidity problem.

That doesn’t mean that Beijing’s efforts will have no impact. Because financial breakdowns and contagion are caused by mismatches in balance sheets, rather than by negative equity, treating the events as if they mainly reflect a liquidity problem can be an effective way of preventing or limiting financial contagion.

By restructuring liabilities – namely, by forcing state-affiliated lenders to replace disappearing deposits and customer liabilities – and by providing as much liquidity as necessary, the regulators can effectively slow down the liquidation process and prevent banking panics.

But these measures do not and will not solve the underlying problems. These problems include the following:

  • Liabilities not backed with debt-servicing capacity: While rising insolvencies have been managed by forcing the liabilities directly or indirectly onto the balance sheets of governments and larger banks, these measures don’t address the key problem, which is that liabilities are being backed by nominal assets that do not generate enough revenues (either directly or in the form of externalities) to cover the debt-servicing costs. This means that these debts can only be serviced by implicit or explicit transfers from other sectors of the economy (as I explain here).
  • Ongoing distortions in fiscal and monetary policy: To the extent that restructuring and guaranteeing liabilities allows insolvent entities to remain in operation, the monetary and fiscal policies needed to sustain them (which almost always include, but are not limited to, very low interest rates) may distort the normal functioning of the economy to the relative detriment of healthier entities. There is a great deal of historical evidence that suggests that economies that postpone necessary financial adjustments tend to recover much more slowly than economies that allow rapid bankruptcies and temporary financial instability.
  • Self-reinforcing economic ripple effects: Large parts of the Chinese economy and financial system continue to be structured around highly risky, inverted balance sheets. This means that they are susceptible to rising insolvency as the economy’s long-running underlying assumptions – rising asset values, expanding liquidity, and monetary stability – continue to change.
  • Overly ambitious GDP growth goals: Beijing still sets very high GDP growth targets that exceed the ability of the economy to deliver high-quality (that is to say, unlevered) growth. As a result, local governments have no choice but to further increase overall leverage, either directly or through the banks.

Under these conditions, it is hard to predict what will happen over the short term. My best guess is that because of the Chinese Communist Party’s upcoming National Congress, Chinese regulators will prioritize stability over all other things.

Any additional outbreaks within the financial system will quickly be absorbed by local government borrowing and the bigger banks. Once the pandemic lockdowns end, the regulators may even unleash a series of “bazooka-like” policies to try to reverse [investor?] sentiments, kick-start rising property prices, and boost confidence among creditors and depositors.

But even if this works temporarily, it cannot go on forever. At some point, Beijing must take concrete steps to allocate the costs of rising insolvency, most likely to local governments, although this will not be easy. If it doesn’t do so, eventually the debt levels will become unsustainable and, perhaps with an evaporation of credibility, the system will force its own allocation of costs.

The latter scenario is usually referred to as a debt crisis, and while I think a debt crisis in China is still very unlikely, this is because I think Beijing still has the ability to restructure liabilities. But one way or another, losses must (and will) be forced onto some sector of the economy, either explicitly as a political decision or implicitly as the economy adjusts to allocate the losses to those sectors least able to protect themselves.

Afterword: Beijing Versus Local Governments

This leads to the last part of this blog post, which is tangential to the discussion above but nonetheless relevant. Resolving China’s debt burden and rebalancing the sources of demand in the Chinese economy may have an important impact on the distribution of power within the Chinese government. More specifically, this process may exacerbate and intensify a conflict between Beijing and provincial and municipal government officials.

We must start by recognizing that the economic costs that must eventually be allocated and absorbed are quite substantial. The costs of resolving China’s bad debt are large enough, as I discuss above, but there is also the cost of rebalancing demand within the economy.

China invests roughly 20 to 30 percentage points of GDP annually in the property and infrastructure sectors of the economy (while total investment is roughly 40 to 45 percent of GDP and property and infrastructure each account for roughly one-third of total investment).

This is far too high a share of GDP to be sustainable and must (and eventually will) come down sharply. But supply and demand must balance, and for large economies that cannot count on ever-growing trade surpluses, a reduction in the investment share of GDP is just the obverse of an increase in the consumption share.

This has an important implication for the distribution of income. If the domestic share of Chinese consumption is to become an important enough driver of growth to accommodate a sharp reduction in the investment share, Chinese households will directly or indirectly have to retain a share of GDP that is at least 10 to 15 percentage points greater than their current share and, conversely, some other sector or sectors must suffer a 10 to 15 percentage point reduction.

There are various ways in which this could happen, many of them very painful and value-destroying, but the way that would be least damaging to the economy involves implicit or explicit transfers from one of the non-household sectors of the economy to the household sector.

Beijing is unlikely to force the bulk of the rebalancing costs onto the business sector (through measures like higher taxes, higher wages, or lower subsidies, for example) because doing so would destroy the main engine of healthy and sustainable economic growth.

Given its desire to reduce its dependence on foreigners for agricultural and industrial commodities, it is also unlikely to force the bulk of rebalancing costs onto the agriculture and mining sectors.

That leaves the government as the only sector that can ultimately bear these costs. But which level of government – local governments or the central government?

Given its centralizing tendencies, my assumption is that Beijing will try to force local governments to absorb the bulk of the adjustment costs, which means ultimately stripping them of a substantial share of their revenue sources and, perhaps more importantly, their assets.

The required transfer is large enough that it will almost certainly result in a major redistribution of political power, making this decision among the most important and contentious political decisions China is likely to face for many years.

While this process hasn’t started in earnest yet, it seems to be the logical culmination of the way Beijing has handled the limited adjustments China has already made toward a new growth model.

National policymakers have already come down hard on the property sector, which was a major source of revenue for local governments, and while it now seems that it underestimated the economic impact of its attempts to slow down the out-of-control property sector, it is pretty clear that it had long wanted to do this anyway.

Beijing’s next step is to control the ability of local governments to raise large and risky amounts of debt. In that light, it is helpful to refer to what Adam Y. Liu, Jean C. Oi, and Yi Zhang referred to as the “grand bargain” of the mid 1990s. They describe it like this:

While much scholarly attention has been paid to the consequences of the 1994 reform that left localities with a tremendous fiscal gap, our findings show that Beijing in fact gave localities the green light to create new backdoor financing institutions that counteracted the impact of fiscal recentralization. In essence, these institutions were the quid pro quo offered to localities to sustain their incentive for local state-led growth after 1994. The bargain worked, and growth continued. The drawback, however, was that China’s economic growth has been accompanied by the accumulation of local government debt with little transparency and central control.

It seems that the conflict in the mid-1990s between Beijing and local government officials was postponed, not resolved, by this “grand bargain” and that this conflict may be reemerging as Beijing tries to bring local government debt under control.

The spending of local governments seems to be rising, especially as local governments are still responsible for generating the additional growth needed to bridge the large gap between what Beijing calls high-quality growth (the sustainable, healthy growth generated primarily by consumption, exports, and business investment) and the country’s politically determined GDP growth targets.

If, at the same time, the revenues of local governments are permanently reduced, local governments will need to avail themselves of even more debt financing to bridge the gap between rising spending and declining revenues. But this won’t be easy. Because Beijing is determined to regain control of such borrowing, it is limiting the borrowing ability of local governments.

The only way to square that circle, I would argue, is ultimately for local governments to liquidate or otherwise deploy their extensive ownership of real estate and state-owned enterprises to fund what in effect must be a major transfer of income and wealth, both to resolve bad debt and to increase the household sector’s share of GDP.

This will inevitably be a difficult process and might prove politically disruptive, but one way or another I expect it to be at the heart of China’s adjustment process over the next several years.

Ally Financial downgraded to Underweight (Piper) As Auto Lending faces headwinds

Piper Sandler analyst Kevin Barker downgraded Ally Financial (NYSE:ALLY) stock to Underweight from Neutral on Monday due to rising default rates and a sharp rise in funding costs.

“We note ALLY has increased the advertised rate on savings deposits by 75 bps over the past three months and 30-day+ delinquency rates are up ~50% Y/Y,” Barker wrote in a note to clients. “These adverse trends are likely to continue for the next several quarters and present a material headwind to earnings.”

He also pointed out that Ally Financial’s (ALLY) leverage is relatively high vs. its peers and previous cycles, which indicates the company has limited flexibility in the event of sudden adverse market movements.

Its valuation looks attractive, but Barker sees limited catalysts. The analyst could become more positive on the stock if the Federal Reserve pulls back on rate hikes and if rates across the curve were to fall.

Ally (ALLY) shares are falling 0.8% in Monday midafternoon trading. The Underweight rating is more bearish than the Quant rating of Hold and contrasts with the average SA Author’s rating of Buy and the average Wall Street rating of Buy.

SA contributor Tim Travis, by contrast, has a Strong Buy rating on Ally (ALLY), citing its sustainable 16%-18% ROTCE

Housing Market Fears Creating Huge Opportunities

It’s easy to think a housing market crash is just around the corner. Home prices surged during the pandemic to unfathomable levels. But due to ultra-low mortgage rates, those home prices were still quasi-affordable. Now those mortgage rates are spiking, and home affordability is crashing. As a result, lots of buyers are backing out of the market. You’re seeing lots of price cuts on homes for sale, and existing home sales are dropping precipitously.

This is certainly starting to feel like the beginnings of a housing market crash.

 

A graph depicting the change in existing US home sales
© Provided by InvestorPlaceA graph depicting the change in existing US home sales

But it’s not — far from it.

Talking heads are saying the housing market is about to crash like it’s 2008 all over again. But what we’re seeing today is the farthest thing from a 2008 repeat.

Instead, the market is normalizing, not crashing. And it’ll sustain healthy growth trends over the next few years.

And in fact, we talked all about these housing market movements in our latest episode of Hypergrowth Investing.

The opportunity? Wall Street has given into these fears of a housing market crash. And it’s left certain housing-related stocks trading at absurdly cheap valuations. Once time proves that these crash fears are baseless, those stocks will fly higher.

We’re talking potential 2X, 3X, even 5X gains in certain housing-related stocks in less than 12 months

Low asset supply coupled with its high demand leads to that asset’s high prices Conversely, high supply coupled with low demand leads to that asset’s low prices.

The housing market is no different. When home supply is low and demand is high, home prices go up. When home supply is high and demand is low, home prices go down.

Normally, the supply-demand fundamentals in the housing market are pretty balanced. Demand is durable because the desire to own a home is fairly steady over time. Supply fluctuates but normally within a well-defined range. The result — home prices almost always go up.

There are rare exceptions, and 2008 was the largest of them all. In that year, you had a confluence of unusually high supply converging on unusually low demand. And that resulted in the largest housing market crash in U.S. history.

 

Graphs depicting the change in the Case-Shiller index/NAHB/home inventory in 2008
© Provided by InvestorPlaceGraphs depicting the change in the Case-Shiller index/NAHB/home inventory in 2008

But that was an exceptionally rare occurrence. Indeed, it takes a lot to move home prices down. You need demand to fall out and supply to boom, which almost never happens.

It did happen in 2008. But it’s not happening in 2022. And the fact that it’s not is creating some big buying opportunities.

Demand in the Housing Market Is Still Strong

A lot of folks are concerned about the falling demand for homes. But those concerns are very premature.

When it comes to demand, there are two inputs — desire and ability. Do people want to buy a house? Can they afford a house?

The answer to both is still “yes.”

The NAHB index for the traffic of prospective buyers is probably the best metric for gauging home-buying desire. It measures buyer traffic in the housing market in any given month. If folks are going to see homes, they’re likely interested in buying one.

That index currently stands at 55. That’s down from where it was throughout 2021 (above 60). But it’s also well-above where it was when home prices started to decline in the early 1990s (sub-20 readings) and the late 2000s (sub-20 readings).

 

A graph depicting the change in the NAHB index
© Provided by InvestorPlaceA graph depicting the change in the NAHB index

The desire to buy a home is still about triple where it was during previous periods of home price declines.

What about affordability? It’s crashing, yes.

But the U.S. Fixed Housing Affordability Index currently sits at 102.5. That’s also above the sub-100 readings we had during the two previous eras of home price declines. That means that while affordability is dropping, it still isn’t at “panic” levels. And so long as mortgage rates don’t keep spiking, the current level of affordability is entirely sustainable.

 

A graph depicting the change in US fixed housing affordability
© Provided by InvestorPlaceA graph depicting the change in US fixed housing affordability

On the demand side of the housing market equation, then, we aren’t seeing any huge warnings signs yet.

Affordability is under pressure, sure, but desire is still strong. And that combination means that as long as mortgage rates stabilize, housing market demand will remain healthy for the foreseeable future.

That’s very bullish for housing-related stocks.

Supply Is Very Low

The reason we’re so confident in our call that the housing market is not crashing has to do with supply.

We’re currently in the most under-supplied housing market in history.

There are presently less than 1.3 million homes for sale in the U.S. housing market. That means that at current buying rates, it would take about 3 months to clear the entire supply (months’ supply).

Those are abysmally low numbers.

For example, when home prices started to go flat in 2005, housing inventory numbered about 3 million homes. And months’ supply clocked in around five months. Home prices didn’t start to decline until 2007. That’s when inventory shot up to 4 million homes, and months’ supply ballooned to 10 months.

 

Graphs depicting the change in US homes inventory/supply
© Provided by InvestorPlaceGraphs depicting the change in US homes inventory/supply

In short, the last time home prices declined, the housing market supply was about 4X bigger than it is today. We had 4X the number of homes for sale on the market. And it took 4X longer to clear all those homes than it does today.

With supply this low and demand still pretty robust, it’s almost impossible that we see home prices take a big hit. Could they fall? Yes, but not by much. There’s simply too much demand chasing too few homes to warrant a big price drop.

In the absence of a big price drop, certain housing stocks look like multi-bagger opportunities at the current moment.

The Final Word on the Housing Market

Home prices don’t always go up.

But since 1960, they’ve gone up on a year-over-year basis about 90% of the time. And when they go down, they barely drop, with an average year-over-year decline of less than 4%.

In other words, home prices rarely go down. And when they do, it’s not by much. To see a repeat of the 2008 crash, you’d need a lot of external forces to create that situation.

We simply don’t have those forces today.

We’re in the most under-supplied U.S. housing market in history with still-decent demand. That’s a combination that’s far from extreme enough.

So… what will happen to home prices over the next few years?

Home price growth will moderate significantly. Currently, prices are rising by about 15% year-over-year. Since 1960, the average annual home price growth rate has been around 5%. We think we undershoot that for a few quarters and fall to 0% to 2% growth until affordability increases. Then, we’ll get right back to that historically normal 5% growth rate.

Expect a housing market slowdown over the next 12 months, followed by a resumption of historically normal growth trends.

We’re staring at a normalization — not a crash.

There is a silver lining to these pessimistic fears, though. Certain housing-related stocks are priced for a crash. They’re trading like its 2008 all over again, but it’s not. And once the market figures that out, these undervalued housing stocks will soar!

We have the No. 1 stock to buy for this housing market resurgence over the next 12 months.

It’s the most undervalued housing stock in the market today. It has more growth firepower than all the other housing stocks put together. And it holds so much long-term potential that it’ll make your jaw drop.

Historic Bond Market Decline recovers as 10-year Treasury yield jumps back above 3%; recession warning still in place

The primary reason for the historic drawdown was the Federal Open Market Committee’s (FOMC) adoption of a significantly tighter monetary policy in response to raging domestic inflation, which signaled multiple short-term rate increases.

Historical Performance Review
Source: Sage, Bloomberg

 *Annualized for 3, 5, 10-year periods

What was notable about the recent selloff was that the U.S. bond market has had positive returns, before inflation, in all but four years since 1976. Indeed, even in 1994 when the Federal Reserve raised interest rates six times for a total of 2.5%, the Aggregate Bond Index lost only 3%. According to the asset return research of Professor Emeritus of Business Edward McQuarrie of Santa Clara University, the losses sustained by the bond market thus far this year surpassed the 17% losses realized for the 12 months ending in March 1980. Moreover, the losses thus far in 2022 are worse than any complete year since 1792 except for 1842 when the U.S. suffered a deep economic depression.

 

 

First half performance for fixed income was particularly difficult for investors because the secular trend for interest rates since 1981 has been down with a concurrent rise in bond prices, which created a long-term tailwind of capital gains. The recent travails of the bond market are even more startling when one considers that in the late summer of 2020, during the first year of the pandemic, the 10-year U.S. Treasury yield of 0.52% reached what may have been the end of the 40-year bull market in bonds that started in in 1981, with yields at 15.8% and the CPI hitting 14.8%.

These adverse market adjustments have also reflected general investor sentiment about the direction of the economy and, in particular, the direction and level of inflation across a wide range of indicators that have remained at levels not anticipated by either the Federal Reserve or the Administration. Investors sensed that these tough economic conditions were more than “transitory” in nature and, as shown below, began to reduce their exposure to fixed income mutual funds and ETFs in earnest.

Monthly Net Flows for Bond Mutual Funds
Source: Investment Company Institute (ICI), Morningstar Research

The fixed income fund withdrawals and ETF liquidations have gone on for seven straight months, the longest consecutive monthly net withdrawal streak on record, equaling more than 2% of total taxable bond fund assets at the end of 2021. Municipal withdrawals for this period were even more dramatic, totaling more than 6% of total municipal bond fund assets at the end of 2021.

Fixed Income Flows
Source: Bloomberg Finance, L.P., State Street Global Advisors, as of June 30, 2022

Thus far this year the investment grade and high yield credit sectors have suffered the brunt of the investor withdrawals or liquidations, contributing to reduced market liquidity and concurrent yield spread widening. These trends are clearly indicated in the chart above. Interestingly, despite the rising rate environment, investor flows have remained positive for U.S. government-focused funds, with the bulk of those positive flows going into short-term investment strategies in anticipation of higher interest rates and a further weakening of the economic environment.

 

Bond vs Stocks: Our Relative Value Outlook

This has been a painful transition for most bond market participants, but it should be no surprise to anyone that near zero interest rates of the last few years were not sustainable. We are confident that we will see further rate hikes, higher inflation, unresolved geopolitical conflicts, and waning growth over the balance of the year. Moreover, the coming U.S. mid-term elections will only add to the concerns of the market and promote further volatility challenges for investors.

To be sure, the low interest rate conditions that favored the TINA (there is no alternative) advocates and stocks have now dissipated. The FOMC’s aggressive policy pivot has caused yields to move higher than they have been in a decade, and as a result, there are plenty of interesting alternatives to be found in the current rubble of the fixed income markets.

It is worth noting that the current 10-year Treasury yield of around 3% is now about 160 basis points higher than the 1.4% dividend yield of the S&P 500 index. This is compressed compared to the long-term average of about 300 basis points. Any near-term widening in this spread due to higher bond yields will decrease the relative attractiveness of stocks and increase the appeal of fixed-income assets, which may in turn continue to place further downside pressure on stocks. Eventually this becomes self-corrective with the further sell-off of stocks and rising dividend yields. We believe this may occur later in the year, but for the moment, this spread trend favors fixed income investments.

We note that while the price/earnings multiple valuation for the S&P 500 Index has ratcheted down from 37x a year ago to the current 20x, the balance of this year will likely see further valuation reductions to about 16x, owing to softer corporate earnings reports, more cautious management forward guidance, higher capital costs, and the continuation of a high inflation/low growth global economic environment.

S&P 500 Yields vs 10 Year Yield: Since 1962
Source: Seeking Alpha

A review of the earnings yield of the S&P 500 versus the 10-year Treasury yield indicates that fixed income investments may have a way to go versus the relative attractiveness of stocks. The earnings yield (the inverse of the P/E ratio) is currently 220 basis points higher than the 10-year Treasury yield. If this spread were to turn negative, it would imply that risk-free assets like Treasuries would be generating superior earnings compared to equities. Now, the S&P 500 earnings yield is above the 10-year Treasury yield, suggesting that stocks still appear attractive in absolute terms. However, we believe that with the coming quarter’s less sanguine earnings reports, equity valuations may come under further pressure. This would lead to a narrowing in this valuation spread and a greater appeal for lower-risk, high-quality fixed income investments.

 

Over the long run the total return of bonds depends far more on their income generation compared to short run changes in price. Investors are wise to remember that since 1976 well over 90% of the total return of the U.S. Aggregate Bond Index came from interest income and the reinvestment of that income over time. It has been said that people always chase the past with their money. We saw this in 2020 when investors chased the higher total returns of fixed income and ended up pouring close to $450 billion into bond funds as yields fell to 1%. According to recent history, those investment actions appear to have been overly optimistic.

The same might be said about the extraordinarily elevated level of pessimism investors have shown by their aggressive fixed income fund withdrawals and ETF liquidations thus far this year. We would argue that with the recent immense decline in bond prices and the comparatively attractive starting yields, investors now have more cushion to absorb the incremental increases in short-term rates that may yet be introduced by the FOMC. These expected policy actions have been priced into the current bond valuations and with those price adjustments we are beginning to see some value emerge across the yield curve and between the various sectors of the market, particularly at the front end of the yield curve.

Trends and Risks We are Following

The FOMC intends to maintain a balanced interest rate policy aimed at reducing inflation to a more manageable level while working to limit the potential slowdown in the rate of growth of the economy, aka the “soft landing” scenario. As noble as that goal may be, given the current global economic slowdown, the ongoing supply chain imbalances that continue to erode consumer and business confidence, and the expected tightening of liquidity that will arise from the Federal Reserve Bank’s (FRB) balance sheet reductions, we are looking for a moderate stagflation environment that may persist until the end of 2023.

Given this environment we anticipate 10-year Treasury bond yields to move between 3% to 3.5% for the balance of this year and begin to decline by the second half of 2023. We also anticipate that market volatility will remain in high gear with the markets testing the ranges regularly in reaction to short-term geopolitical or FRB/government policy stimuli. In the absence of any further unknown external geopolitical shocks, we believe inflationary trends will slowly begin to recede as economic activity cools off from the FOMC’s policy actions. As a result, interest rates will be a bit higher but should be manageable for most consumers and businesses.

The current U.S. employment outlook remains constructive and will be so for the balance of this year. This has allowed the underlying growth in the economy to remain marginally positive, notwithstanding the dour Atlanta Federal Reserve GDP projections for the second quarter. While consumers have pared back their consumption activities and increased their dependency on credit in recent months in reaction to this year’s burst of inflationary cost pressures, their balance sheets overall remain strong. This has also been true for businesses, which should mean that delinquencies and defaults will hopefully remain low.

We believe that investors will begin to return to the bond market over the remainder of the summer after the next 75-basis-point federal funds rate increase has been introduced this month. There may be more rate increases ahead, but in our view the FRB would be well advised to take a market intervention break until well after their late August Economic Symposium in Jackson Hole. In the meantime, we believe investors should be focused on identifying companies with durable cash flow metrics, dominant market positions, and solid balance sheets across a range of market sectors, with a particular focus on investing in medium quality-rated credits that have been overly discounted in the recent sell-off.

 

Lastly, we believe investors need to keep sight of what the late Donald Rumsfeld referred to as the “known unknowns.” First, the Russia/Ukraine conflict continues to rage on, and it could be our No. 1 joker in the deck in terms of potential adverse or positive market impacts depending how these hostilities play out. Stay tuned.

Second, new COVID-19 variant outbreaks around the globe persist, particularly in China. Government policies toward containment of these infections remain fluid but may become more restrictive as infection statistics rise and summer in the Northern Hemisphere ends. China’s current “no tolerance” policy has kept global economic activity at bay and has prevented a much greater increase in inflationary pressures than might have otherwise been realized by most other developed economies. How long this remains to be the case will be an important determinant for markets in the months ahead.

Third, the FRB’s efforts to contain supply side-driven inflationary trends with aggressive monetary policy fail to contain the rise in consumer inflation measures and cause negative reactions across the capital markets and asset values. This could be compounded by a policy whipsaw where the central banks in their frustration accelerate the removal of their past accommodation and thereby further undermine the intended global expansion.

Sources

Bartolini, Matthew. The Endless Summer… of Volatility? State Street Global Advisors SPDR. June 30, 2022.

Bespoke Investment Group. S&P 500 Yields Vs. 10-Year. Seeking Alpha. June 13, 2022.

Zweig, Jason. It’s the Worst Bond Market Since 1842. That’s the Good News. The Wall Street Journal. May 6, 2022.

How Rivian and Lucid Can Threaten Tesla amid employee layoffs

Tesla’s recent layoffs may come back to haunt it as rivals rush to recruit its former workers

  • Tesla (TSLA) conducted multiple worker layoffs in June 2022.
  • But rival electric vehicle (EV) producers are welcoming them.
  • This trend could help Lucid (LCID) and Rivian (RIVN) expand at the expense of Tesla.
 

Tesla (NASDAQ:TSLA) stock has seen plenty of turbulence lately. And one recurring theme through the second quarter of 2022 has been layoffs.

When Elon Musk warned that the company would be laying off 10% of its workforce due to his economic fears, TSLA stock plunged. He ultimately walked back this claim but less than a month later, Tesla conducted a mass layoff, leading to a lawsuit from former employees. This news didn’t push TSLA stock down.

However, as it turns out, there may be another problem that ensues from the layoffs. Tesla’s rivals are rushing to recruit its laid off staffers.

Loss and Gain 

“Tesla Inc. workers facing layoffs should take heart — their services are in high demand by the company’s rivals and other tech giants,” reports the Silicon Valley Business Journal.

Indeed they are. Private executive network Punks and Pinstripes has released a report on Tesla’s former workers. According to its data, 457 workers have left Tesla over the past 90 days. Many companies are rushing to hire them, though, and Tesla’s top rivals are among them. The report found that Rivian (NASDAQ:RIVN) has hired 56 former-Tesla staffers, while Lucid Group (NASDAQ:LCID) hired 34. This means that 90 ex-Tesla employees are now employed by the EV producers looking to overtake it.

It’s no secret that Tesla is facing production problems. After it reported disappointing earnings for Q2 2022, factories in Shanghai and Berlin were placed on pause. This news came after Elon Musk referred to his factories as “giant money furnaces.” Now Musk has is hinting at “long-term trouble” ahead, giving TSLA stock investors more cause for concern.

 

Musk trimming Tesla’s workforce is clearly aimed at cutting costs at a difficult time. It’s not hard to see why he did it. But this is exactly the type of story that should be examined through a macro lens. When Tesla lays off qualified workers, the first logical move for the laid off staffers is to take their talents to fellow EV makers. And when they do, their new employers benefit at the expense of the former.

It’s no surprise that both Rivian and Lucid were so quick to hire ex-Tesla team members. At a time when Tesla is pausing production, both companies are expanding. Lucid recently secured approval to lease a factory facility in Arizona. And Rivian has been rising recently on positive delivery updates, the opposite of what investors have seen from Tesla. Both companies have outperformed TSLA stock this week.

Upcoming Challenges

Both Lucid and Rivian have made it clear that they want Tesla’s spot as leader of the EV race. Stocking up on former Tesla staffers is great way to ensure that they reach it. As these new additions to their teams help the companies grow and scale production, Tesla is likely to regret letting so many people go.

InvestorPlace senior analyst Luke Lango has long believed in Lucid’s growth potential. “My bullishness on LCID is derived from its elite EV technology and talent” he states. “Lucid’s team comprises folks from the two best consumer hardware companies on Earth — Tesla and Apple (NASDAQ:AAPL).”

Lango issued that take in April 2022. Now that Lucid has added even more former Tesla staffers, it will be better equipped than ever to keep growing. And as its rival continue to expand, Tesla will suffer as its market share shrinks.

5 Best Stocks According to Citadel Billionaire Ken Griffin

Advanced Micro Devices, Inc. (NASDAQ:AMD)

Citadel Investment Group’s Stake Value: $254.91 million Percentage Of Citadel Investment Group’s 13F Portfolio: 0.05% Number of Hedge Fund Holders: 83

Advanced Micro Devices, Inc. (NASDAQ:AMD) starts off our list of billionaire Ken Griffin’s favorite tech stocks. The California-based firm provides graphic cards, microprocessors, and motherboard chipsets that are used in PCs, smartphones, workstations, and data center servers around the world.

Ken Griffin’s stake in Advanced Micro Devices, Inc. (NASDAQ:AMD) during the first quarter consisted of 2.33 million shares valued at $254.9 million, representing 0.05% of his total portfolio. This was a 3% reduction over the previous quarter. In total, 83 hedge funds were long on the company shares at the close of the first quarter, up from 69 hedge funds a quarter ago. Fisher Asset Management increased his position in Advanced Micro Devices, Inc. (NASDAQ:AMD) by 23% in the first quarter, becoming its biggest shareholder with a $2.66 billion stake.

On June 22, Morgan Stanley analyst Joseph Moore resumed coverage of Advanced Micro Devices, Inc. (NASDAQ:AMD) with an ‘Overweight’ rating and a $103 price target. He sees the firm as well-positioned to post share gains over the next two years, and notes that it will continue to increase its share in the cloud services market as supply constraints ease.

In the first quarter, Advanced Micro Devices, Inc. (NASDAQ:AMD) posted earnings per share of $1.13, surpassing Street estimates by $0.20. Revenue of $5.89 billion was also above estimates by $358.26 million.

Investment firm Carillon Tower Advisers talked about Advanced Micro Devices, Inc. (NASDAQ:AMD) in its Q4 2021 investor letter. Here’s what the fund said:

Advanced Micro Devices (AMD) supplies semiconductor chips for central processing units (CPUs) and graphic processing units (GPUs). The firm has been gaining share against its primary competitor in the datacenter server CPU space, as this rival has been unable to match the design and manufacturing capabilities of AMD and its partners. Investors are also looking forward to the closing of the previously announced merger with a semiconductor manufacturer that is another one of the portfolio’s holdings. The merger will increase AMD’s capabilities in the Field Programmable Gate Array (FPGA) chip space, and the combined company should possess the potential to win additional market share in the datacenter chip market.”

Broadcom Inc. (NASDAQ:AVGO)

Citadel Investment Group’s Stake Value: $301.52 million Percentage Of Citadel Investment Group’s 13F Portfolio: 0.06% Number of Hedge Fund Holders: 71

Broadcom Inc. (NASDAQ:AVGO) is a semiconductor manufacturer based in California, which operates through its segments: Semiconductor Solutions and Infrastructure Software. Ken Griffin increased his stake in the firm by 213% in the first quarter, standing at roughly 479,000 shares worth $301.5 million. In comparison, the billionaire owned 153,000 shares of Broadcom Inc. (NASDAQ:AVGO) a quarter ago.

On May 27, Mizuho analyst Vijay Rakesh reiterated a ‘Buy’ rating on Broadcom Inc. (NASDAQ:AVGO) shares and raised the price target to $725 from $700. He holds that the company’s planned acquisition of VMware (NYSE:VMW), a US-based cloud computing company, potentially unlocks 45% upside. Financial Times recently reported that the deal is set to undergo a lengthy antitrust investigation in the EU over concerns it could possibly harm competition across the global tech industry.

Investors were seen piling into Broadcom Inc. (NASDAQ:AVGO). At the end of the first quarter, 71 hedge funds owned positions in the firm, as compared to 62 hedge funds a quarter earlier. Its largest Q1 shareholder was Fisher Asset Management with a position worth nearly $895 million.

Broadcom Inc. (NASDAQ:AVGO) announced its Q1 earnings on May 26, and disclosed earnings per share of $9.07, beating estimates by $0.35. Quarterly revenue was recorded at $8.1 billion, exceeding market forecasts by $194.74 million and representing a 22.6% jump from the year-ago quarter.

 Uber Technologies, Inc. (NYSE:UBER)

Citadel Investment Group’s Stake Value: $338.03 million Percentage Of Citadel Investment Group’s 13F Portfolio: 0.06% Number of Hedge Fund Holders: 144

Uber Technologies, Inc. (NYSE:UBER) is up next on the list of top tech stocks to buy according to Ken Griffin. The billionaire owned 9.47 million shares of the firm at the end of the first quarter, priced at around $338 million. This was a decrease of 37% over the previous quarter, where he owned roughly 14.91 million shares of Uber Technologies, Inc. (NYSE:UBER).

The popular ride-hailing firm has seen diminishing investor confidence as of late. At the close of Q1 2022, 144 hedge funds owned positions in Uber Technologies, Inc. (NYSE:UBER), as compared to 153 hedge funds a quarter earlier.

On June 9, Goldman Sachs analyst Eric Sheridan reduced the firm’s price target on Uber Technologies, Inc. (NYSE:UBER) to $45 from $55, and maintained a ‘Buy’ rating on the shares. The analyst has updated his model to reflect a greater probability of a weaker macro environment, and is taking a more conservative view on the ride-sharing and food delivery sectors. Uber Technologies, Inc. (NYSE:UBER) recently announced that its popular ride-sharing feature called UberPool would be relaunching under the name UberX Share. This service was cancelled amid the Covid pandemic, and will now be available in a number of major US cities.

ClearBridge Investments, an investment management firm, mentioned Uber Technologies, Inc. (NYSE:UBER) in its Q3 2021 investor letter. Here’s what it said:

“We have also been looking for multiyear secular trends outside of the IT and Internet sectors to help us maintain a portfolio that can perform well in markets with varied sector or factor leadership. In particular, electrification of the global economy and the transition to electric vehicles (EVs) are areas where we continue to add exposure. We are investing in the brains behind EVs through NXP in the control center and Aptiv for safety features. Global rideshare leader Uber Technologies, Inc. (NYSE:UBER) will also be a key player in the transition from internal combustion engines to EVs.”

Visa Inc. (NYSE:V)

Citadel Investment Group’s Stake Value: $348.52 million Percentage Of Citadel Investment Group’s 13F Portfolio: 0.07% Number of Hedge Fund Holders: 159

Visa Inc. (NYSE:V) is a digital payments company headquartered in California. Ken Griffin owned 1.57 million shares of the company at the end of March, worth $348.5 million. This was an increase in stake of 4% over the previous quarter, and amounted to a 0.07% slice of his overall portfolio.

Baird analyst David Koning on June 22 named Visa Inc. (NYSE:V) as his “bullish Fresh Pick”, and kept an ‘Outperform’ rating on the shares with a $290 price target. He noted that the firm would likely remain quite resilient in a recession-scenario given growing purchase volume. Koning is bullish on Visa stock as cross-border transactions and inflation provide ongoing growth drivers.

Investors were seen buying Visa Inc. (NYSE:V) stock. At the end of March, 159 hedge funds were long on the company shares, as compared to 142 hedge funds a quarter earlier. The combined value of Q1 hedge fund holdings stood at more than $28 billion. The largest shareholder of Visa Inc. (NYSE:V) during the first quarter was TCI Fund Management with a $4.41 billion stake.

In the first quarter of 2022, Visa Inc. (NYSE:V) reported earnings per share of $1.79, exceeding estimates by $0.14. $7.19 billion in revenue for the quarter registered year-on-year growth of 25.5% and also beat market forecasts by $365.4 million.

Here is what Polen Capital, an investment firm, had to say about Visa Inc. (NYSE:V) in its Q1 2022 investor letter:

“We added to both Visa and Mastercard during the final quarters of 2021, based on the belief that both businesses were trading at attractive prices and poised to deliver, double-digit returns over the next three to five years. Cross-border transactions–a highly profitable business segment for both companies–represent roughly 10% of Visa and Mastercard’s volumes and 25% of their gross revenues, so lockdowns have severely impacted this segment due to stifled travel. While it was impossible to know when people would begin traveling again, we accepted this reality with the belief that travel would eventually return. Both companies have commented that as soon as a country or geography reopens, cross-border volumes reignite, amplifying each business’s growth and profitability. We think these near- term headwinds have created an attractive long-term investment opportunity.”

Tesla, Inc. (NASDAQ:TSLA)

Citadel Investment Group’s Stake Value: $370.64 million Percentage Of Citadel Investment Group’s 13F Portfolio: 0.07% Number of Hedge Fund Holders: 80

Tesla, Inc. (NASDAQ:TSLA) is an EV manufacturer based in the United States. The company stock represented 0.07% of Ken Griffin’s Q1 portfolio, with roughly 344,000 shares valued at $370.6 million. This showed an increase of 20% over the previous quarter where Griffin owned 289,000 Tesla shares.

On June 24, Credit Suisse analyst Dan Levy maintained an ‘Outperform’ rating on Tesla, Inc. (NASDAQ:TSLA) shares and lowered the price target to $1,000 from $1,125. Despite forecasting lower than expected Q2 deliveries, the analyst retains a bullish outlook on Tesla and sees its long-term fundamentals remaining intact. He also notes that widening supply chain issues could extend Tesla’s lead over other firms in the EV space.

Out of all the hedge funds tracked by Insider Monkey, 80 reported ownership of stakes in Tesla, Inc. (NASDAQ:TSLA) at the close of the first quarter with a combined value of $11.28 billion. This is down from 91 hedge funds a quarter ago. Its largest Q1 shareholder was Cathie Wood’s ARK Investment Management, a long-time investor, with a $1.71 billion stake.

Grantham Mayo Van Otterloo & Co. LLC, an investment management firm, mentioned Tesla, Inc. (NASDAQ:TSLA) in its Q1 2022 investor letter. Here’s what the fund said:

“To put the demand growth for clean energy materials into perspective, let’s look at Tesla (NASDAQ:TSLA). At its Battery Day last year, Tesla projected three terawatt hours of lithium-ion battery capacity needed in 2030 for the EVs and storage they expect to produce. To reach this target, Tesla alone would gobble up approximately 75% of the world’s current nickel production and four times the world’s current lithium production. These numbers are astounding enough, but when one considers that EVs currently represent just 15% of global nickel demand and about 45% of lithium demand and that Tesla will likely be producing only a small proportion of the world’s EVs in 2030, the implications are staggering. Clean energy materials companies will make a lot more money in the decades to come than they ever have both because they will be selling a lot more metric tons of material and because there are certain to be shortages where supply can’t keep up with the rapidly growing demand.”

Wall Street layoffs ahead as two-year hiring boom turns to bust; fixed income stays strong

 

Traders to the rescue?

The saving grace on Wall Street this year has been a pickup in some areas of fixed-income trading. Greater volatility in interest rates around the world, surging commodity prices and inflation at multi-decade highs has created opportunities. JPMorgan’s Pinto said he expected second-quarter markets revenue to increase 15% to 20% from a year earlier.

That too may eventually be under pressure, however. Banks will need to carefully manage the amount of capital allocated to trading businesses, thanks to the impact of higher interest rates on their bond holdings and ever-stricter international regulations.

For employees who have been resisting return-to-office mandates, the time has come to head back, according to McCormack.

“Banks have been very clear about trying to get people back to work,” he said. “If you aren’t stellar and you are continuing to work from home, you are definitely most at risk.”

Less than six months ago, Wall Street bankers were reaping the rewards from a historic boom in mergers and IPOs.

Now, thanks to a confluence of factors that have cast a pall over markets and caused most deal categories to plunge this year, broad-based job cuts loom for the first time since 2019, according to industry sources.

 

The turnaround illustrates the feast-or-famine nature of Wall Street advisory work. Firms were caught understaffed when central banks unleashed trillions of dollars in support for markets at the start of the Covid-19 pandemic. The ensuing surge in capital markets activity such as public listings led to a bull market for Wall Street talent, from 22-year-old college graduates to richly compensated rainmakers.

For the first time in years, bank employees seemed to gain the upper hand. They pushed back against return-to-office mandates. They received record bonuses, multiple rounds of raises, protected time away from work and even Peloton bicycles.

But that’s over, according to those who place bankers and traders at Wall Street firms.

“I can’t see a situation where banks don’t do RIFs in the second half of the year,” David McCormack, head of recruitment firm DMC Partners, said in a phone interview. The word “RIF” is industry jargon meaning a “reduction in force,” or layoffs.

‘Very challenging’

The industry is limping into the traditionally slower summer months, squeezed by steep declines in financial assets, uncertainty caused by the Ukraine war and central banks’ moves to combat inflation.

 

IPO volumes have dropped a staggering 91% in the U.S. from a year earlier, according to Dealogic data. Companies are unwilling or unable to issue stock or bonds, leading to steep declines in equity and debt capital markets revenues, especially in high yield, where volumes have fallen 75%. They’re also less likely to make acquisitions, leading to a 30% drop in deals volume so far this year.

Wall Street’s top executives have acknowledged the slowdown.

Last month, JPMorgan Chase President Daniel Pinto said bankers face a “very, very challenging environment” and that their fees were headed for a 45% second-quarter decline. His boss, CEO Jamie Dimon, warned investors this month that an economic “hurricane” was on its way, saying that the bank was bracing itself for volatile markets.

“There’s no question that we’re seeing a tougher capital markets environment,” Goldman Sachs President John Waldron told analysts at a conference this month.

The industry has a long track record of hiring aggressively in boom times, only to have to turn to layoffs when deals taper off. The volatility in results is one reason investors assign a lower valuation to investment banks than say, wealth management firms. In the decade after the 2008 financial crisis, Wall Street firms contended with the industry’s declining revenue pools by implementing annual layoffs that targeted those perceived to be the weakest performers.

‘Fully staffed’

Banks paused layoffs during the pandemic bull market as they struggled to fill seats amid a hiring push. But that means they are now “fully staffed, perhaps over-staffed for the environment,” according to another recruiter, who declined to be named.

The numbers bear that out. For example, JPMorgan added a net 8,000 positions at its corporate and investment bank from the start of 2020 to this year’s first quarter. The biggest Wall Street firm by revenue now has 68,292 employees, 13% more than when the pandemic began.

Headcount jumped even more at Goldman in the past two years: by 17%, to 45,100 workers. Employee levels at Morgan Stanley jumped 26%, to 76,541 people, although that includes the impact of two large acquisitions.

The math is simple: Investment banking revenue may be falling back to roughly pre-pandemic levels, as some executives expect. But all the major firms have added more than 10% in headcount since 2020, resulting in a bloated expense base.

“When banks have a revenue problem, they’re left with one way to respond,” said McCormack. “That’s by ripping out costs.”

The recruiter said he expects investment banks will trim 5% to 8% of workers as soon as July, after second-quarter results are released. Analysts will likely pressure bank management to respond to the changing environment, he said.

Sources close to JPMorgan, Goldman and Morgan Stanley said they believed that the firms have no immediate plans for broad layoffs in their Wall Street operations, but may revisit staffing and expense levels later this year, which is a typical management exercise.

Banks are still selectively hiring for in-demand roles, but they are also increasingly allowing positions to go unfilled if workers leave, according to one of the people.

“Business has dropped off,” another person said. “I wouldn’t be surprised if there was some type of headcount reduction exercise in the October-November time frame.”