What I’m watching this summer (Part 2)

Last week I picked out the first five of my ten areas to watch this summer – including oil, which has lived up to its volatile billing. As with so much we discussed, pricing is difficult when structural change has ripped up the old playbook.

This week I’m turning my attention to five more issues – many of which also require new thinking. Again, in no particular order, I’m watching: retail, Italy, Brexit, buybacks and soybeans.

Retail

Retail stress tends book-end the year simply because that’s when cash pressures peak. The fact that scarcely a day seems to go by this summer without a profit warning or further store closures feels significant – and all the more noteworthy given that this is a tough, but by no means dire consumer environment.

UK retail environment

What’s different is the combination of sales pressure and rapid structural change.  It’s not just how much is spent, but where it’s being spent and how much retail investment is required to capture that spend in crowded markets.  Bricks and mortar retailers face a double whammy of meeting rising consumer expectations online and in-store. Something has to give.

That’s why we’ll be watching two things. Firstly, for any cash pressures that will only intensify once retailers have to order and pay for Christmas. Secondly, the pace of store closures and rent push back from those who haven’t been through a CVA – but want to remain competitive with peers who have. Landlord stress has been limited thus far by self-help and a low interest rate environment. But, store numbers have further to fall and interest rates further to rise.

Italy

Update: Italy has a government – although history suggests this might not be long lived. Meanwhile Spain might overtake Italy in investor concerns.

And, it’s still worth highlighting recent events in Italy for two reasons.

The first is that they underline the point we’ve made repeatedly here that risk isn’t dead. Central bank support has softened blows – or lessened the fear of them. But, to quote a recent Moody’s headline: Near-term global economic outlook remains strong, but downside risks rise to the surface.

Italy’s real disposable incomes per capita is less now than when it joined the Eurozone. It’s debt is still vast. Structural problems persist – and some of them are indeed surfacing. May’s rise in inflation creates a significant dilemma for the ECB.

Italy & Portugal 2Y

 

The second is to highlight market reactions that provide insight into investor fears. This is an imperfect science given the problem of pricing low risk/high impact events – Italy is too big to fail and save. But there are areas to watch out for.

The initial bond sell off was brutal, but still moderate compared to 2011/12. We also haven’t seen a significant rise in peripheral yields – e.g. in Portugal. This suggests that investors were more concerned about default, but didn’t see this as a contagious crisis of 11/12 magnitude and still bought into the Eurozone recovery story.

It will be interesting to see now how government bonds react in the coming days given that budgetary fiscal risks remain under current spending plans. ‘Quitaly’ risk will also be hard to shake. Newer credit default swaps (CDS) include currency redenomination in their list of default events.  Older CDS don’t. A record spread between the two this week indicated the level of EU exit fear.

Also worth watching the European banking sector. Exposure to Italian sovereign debt has fallen by about 50% in the last ten years, but c.30% of Italy’s bonds are still held by foreign investors.

Brexit

It seems trite to mention Brexit in this context, given that we’ve been watching its progress for almost two years. But there might be something concrete to talk about this summer given the approach of parliamentary votes and the upcoming crunch EU Summit in October – the target date to agree a withdrawal treaty and terms of a transition agreement.

UK Biz Inv

The March 2019 exit date could be largely symbolic, with transition agreements likely to be in place for some time. But businesses still need to plan and investment is worryingly flat. A survey from the Bank of England Decision Maker Panel shows that leaders at more productive companies held the most negative views on Brexit.

So the next few sets of business investment figures will be interesting to watch – as will consumer confidence, with the GfK figures now rooted in negative territory for 29 months, held down by negative views on the economy.

US buybacks vs investment

It’s too early to say anything concrete on the impact of US tax reform, although it seems more than coincidental that US companies purchased a record quantity of their own shares in the first quarter– up 42% on the same period in 2017 and topping the record set in Q3 2007.

But, this isn’t a simple narrative. If we look beyond the headline volumes, the number of buybacks is pretty steady, with five companies accounting for 75% of the latest buybacks. Many of these are technology companies – but these companies are also increasing capex faster than ‘traditional’ businesses.

The other problem we have in assessing where the windfall cash is going is that buybacks are immediately, but capex and M&A take much longer to progress. Just think how long it takes to build a ship! US business investment had its best reading since mid-2014 in Q1 2018 – but much of that will be due to the increase in oil price.

So patience and some summer reading of company statements is in order to get a fuller picture. Buybacks were always going to take the bulk of the cash, but it’s still likely that US companies are also investing internally and in M&A

Soybean prices

The US is one of the world’s biggest producer of soybeans and China is the biggest consumer. Soybeans account for almost two-thirds of US agriculture exports to China – which could now be subject to a 25% tariff subject to US tariffs.

Soybean

Predictably then the on-off US-China trade war is being played out in soybean prices and futures. It might seem like an esoteric area to watch, but soybeans are ubiquitous in the food chain – primarily in animal feed, but also c.60% of processed foods.

Trade tensions are escalating – now see also EU & US –  and no-body wins. To quote the OECD’s economic outlook released this week:

“The threat of trade restrictions has begun to adversely affect confidence, and, if such measures were implemented, they would negatively influence investment and jobs.”