The Transcript Q1 2022 Letter
What we learned from the Q1 2022 earnings calls
Note to our esteemed readers:
Three quarters ago, we began writing a quarterly letter to our subscribers to review the key trends that we saw in the latest earnings season. This week, we are publishing our letter for the Q1 2022 earnings season. Enjoy it! This week’s newsletter is available to all our subscribers, both paid and free.
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Intro
At the time of writing, the S&P 500 is down 16.1% year to date and the Nasdaq is down 25.4%. Rising interest rates have largely driven the declines. The US economy is grappling with the highest inflation that it has experienced in over 40 years. Here’s what The Transcript has chronicled over the last quarter.
Macro
Investors are asking whether this is the end of an era. For nearly 15 years global policymakers have battled a deflationary mindset with near-zero interest rates and quantitative easing. However, a series of supply chain shocks and monetary policy errors have sparked rising long-term inflation expectations. If we have exited the deflation era and entered into an inflationary one, it will mean structural changes in monetary policy, interest rates, and stock multiples. By the Fed’s own account, despite raising interest rates by 0.75% so far this year, it is still only on pace to get to a neutral interest rate by the end of the year. It has not yet entered the restrictive territory, which would usually be justified by >8% inflation.
"We’ve been accustomed to 40 years, basically, of one cycle, the whole cycle that we covered in the last quarterly review. Declining interest rates, declining tax rates, all these trends - - it’s all come to an end. Not just an end, it’s actually changing. But people haven’t wrapped their heads around that yet…There’s going to be a new cycle." - Horizon Kinetics (INFL) Co-Founder Steven Bregman
"An entire generation of entrepreneurs & tech investors built their entire perspectives on valuation during the second half of a 13-year amazing bull market run. The "unlearning" process could be painful, surprising, & unsettling to many. I anticipate denial." - Benchmark Capital General Partner Bill Gurley
While the Fed has talked about getting to “neutral” throughout this quarter, it hasn’t yet set an expectation for what neutral means. There seems to be some consensus that this neutral rate would be a short-term interest rate in the 2.5% - 3.5% range. Equity markets may not yet reflect this new cost of capital.
"I think I'm in the same areas as my colleagues philosophically. I think it's really important that we get to neutral and do that in an expeditious way. " - Atlanta Fed President Raphael Bostic
"I like to think of it as expeditiously marching towards neutral. It's clear the economy doesn't need the accommodation we're providing. And so in order not to tip the economy over by reacting abruptly, we need to take a measured pace. But that measured pace still gets us up to the neutral rate, which I put at about 2.5% by the end of the year." - San Francisco President Mary Daly
The S&P 500 earned $197.87 per index share in 2021. This means that at the beginning of the year, the index sold at 24x peak earnings. It now stands at 20.3x or ~5% earnings yield. Equity values are extremely sensitive to changes in the cost of capital. If the required earnings yield of the S&P 500 were to rise even to 6.5%, it would imply a 15.4x multiple, a ~25% decline from current levels to 3,047. Note that this is about equal to the average earnings multiple of the last 50 years.
None of this analysis takes into account the increased risk of a recession that comes with structural changes in monetary policy. We’re seeing management teams increasingly concerned that higher interest rates and inflation will tip the economy into recession. The Fed is hoping for a soft landing but this almost never happens.
“I think we have a good chance to restore price stability without a recession, without, you know, a severe downturn without materially high, higher unemployment.” - US Federal Reserve Chair Jerome Powell
International
Internationally, the war in Ukraine has been the most important economic story of the last quarter. From a humanitarian perspective, the war has caused unimaginable grief and the global business community expressed its shock and horror. From an economic perspective, the war in Ukraine is the latest supply chain shock to hit the global economy. Ukraine and Russia supply large percentages of the world’s energy and food supply. Disruption to these two economies is being felt around the world in the form of higher prices.
“I have to say it really has upset the world in a huge way." - Visa (V) CEO Alfred Francis Kelly
“...when 30% of the world's wheat is exported from Russia and Ukraine and 25% of the world's corn comes out of that region. And you're a Ukrainian farmer today and the diesel depots have been blown up or you're going to have access to diesel even to plant? And where is that fertilizer going to come from?”- CF Industries (CF) CEO & Director Anthony Will President
The Transcript is also closely watching continued lockdowns in China. The Chinese government’s zero-Covid policy has left hundreds of millions of people in lockdown even though the rest of the world has returned to normal. The effects of this supply chain shock have still not entirely made their way into the economic discussion.
"I think a separate risk is kind of the impact of logistics and supply chains as we deliver product to China and from a more macro perspective just the port closures and the broader impact that we could see in China given the degree of exports they have just generally across the economy. With respect to the China quota difficult to predict." - Intuitive Surgical (ISRG) CFO Jamie Samath
“...the situation in China is unprecedented. Shanghai, a city 4x the size of New York City, is completely locked down...China continues to battle COVID resurgences and navigate through prolonged lockdowns." - Starbucks (SBUX) CEO Howard Schultz
Financials
Capital markets have begun to show signs of seizure as they grapple with sharp declines in equity valuations and a rise in interest rates. IPO windows have been more or less closed this year. Private capital markets had remained more insulated from public market declines, but we are starting to see signs that those markets are being impacted too.
"We are keenly aware that the market is placing a high value on companies generating and expanding profits as interest rates rise." - Uber Technologies (UBER) CEO Dara Khosrowshahi
“…one of the things that happened was a bunch of equity issuance that was supposed to happen in the quarter got pushed out. That definitely is a market volatility effect." - Goldman Sachs (GS) CEO David Solom
Mortgage markets are also slowing significantly. Mortgage lenders are cutting staff and preparing for lower volumes. Housing markets are still buoyed by low supply, but demand may be starting to slow there as well.
"The current cycle...feels more substantive because it is not being driven by speculators purchasing homesites or vacation rentals to flip. Instead, it is being driven by individuals and families moving to live here full time." - St. Joe Company (JOE) President and CEO Jorge Gonzalez
"The homeowner's balance sheet has never been healthier, and our consumers and our Pros tell us that their backlogs have never been healthier." - Home Depot (HD) CFO Richard V. McPhail
Consumer
Surprisingly, consumer spending has still only been moderately affected by surging inflation and falling financial markets. The covid-era stimulus has left consumer bank accounts with lots of reserves and consumers still have a significant amount of pent-up demand for travel, restaurants, and other entertainment. We are expecting to see some slowing of consumer spending and the real economy going forward in sympathy with the dynamics of capital markets.
"March was the eighth straight month in which inflation outpaced income with lower-income consumers being most impacted by rising energy and food prices." - Wells Fargo (WFC) CEO Charlie Scharf
"Consumers are trying to ration their money a little bit more carefully because they're trying to smooth out their cash flow." - Affirm (AFRM) CEO Max Levchin
“when we think about where inflation is, there's absolutely pressure on that low and middle income consumer.” - Macy’s (M) CEO Adrian V. Mitchell
Technology
Technology companies have been hit harder than any other industry by rising interest rates. For more than a decade, technology companies have been able to prioritize long-term growth over profitability. But as the cost of capital rises, priorities have needed to shift. The result is that multiples have cratered and the stocks of many blue-chip technology companies such as Netflix and Facebook have fallen by 50% or more from their peaks. The re-opening of the economy post-Covid has further added to the headwinds for many technology companies. Their growth surged in the work-from-home environment. But comps have gotten much harder as other priorities compete for consumers’ time. The good thing is businesses aren’t cutting IT budgets:
"The interesting thing I find from perhaps even past challenges whether macro or micro is no, I don’t hear of businesses looking to their IT budgets or digital transformation projects is the place for cuts, if anything, some of these projects are the way they’re going to accelerate their transformation or for that matter automation for example." - Microsoft (MSFT) CEO Satya Nadella
Crypto-currency, which was once the hottest investment area of all, has seen its interest wane along with other frontier tech.
“When we look a level deeper, our larger customers are still remaining active. We are seeing more pronounced declines from those that have lower balances. With the uncertainty in the market, our customers became more cautious with their portfolios, trading less frequently and in smaller amounts across all asset classes…crypto activity in particular came down pretty significantly.” - Robinhood Markets (HOOD) CEO Vlad Tenev
Healthcare
Covid has become almost an afterthought for the global economy. Testing and vaccine volumes are expected to fall significantly in 2022. Hopefully, we don’t see a new variant!
“We finally reached the inflection point as we transition from pandemic to endemic.” - United Airlines Holdings (UAL) CEO Scott Kirby
“…it's kind of almost funny that Omicron is almost a thing in memory even though it was ravaging just a couple of months ago but is now behind us in that sense. And we have other bigger things now to deal with." - FedEx (FDX) COO Raj Subramaniam
Industrials
There isn’t a clear consensus on the direction of supply chain problems. Some companies say that things are getting better, while others say that they are about the same. It has felt like every time we make progress a new issue springs up. If we are entering a recession, inventory dynamics will be an important area of focus in Q3 and Q4. Historically in inflationary periods, customers over-order so that they can secure the supply of key components, but when a recession hits these orders do not get fulfilled, leading to an inventory glut.
"Within the supply chain, tight component supply and elongated transportation times continue to be a challenge. However, we have seen some signs of stabilization. For example, our goods in transit for the quarter remained stable and similar to year-end levels. The Port of L.A. has seen improvements with reduced congestion and moving goods from the ports to our DCs is not a significant source of delays." - Stanley Black & Decker (SWK) CEO Jim Loree
"...everybody thinks supply chains are getting better. I don't think we've gotten better at all. I mean it is what it is. I mean, product is on the water for a long time, getting ships into port. It's taken a long time." - RH (RH) CEO Gary Friedman
Energy & Materials
Oil prices have surged thanks to the war in Ukraine, but price increases have moderated some as of late. Gasoline prices are shockingly high. Oil and gas CEOs are increasingly confident and plan to devote more resources toward new CapEx. In the long term, this leads to increased confidence that electric cars are the way of the future. But the transition will not be overnight. It will also bring its own basic resource constraints and cost pressures in commodities such as lithium and copper.
"We expect oil and gas demand will grow over the near and medium-term, driven by economic expansion, energy security concerns, and population growth. At the same time, supply remains under the structural threat of scarcity…Current oil supply tightness and commodity price levels strengthen my confidence in the accelerating multiyear upcycle." - Halliburton (HAL) CEO Jeffrey Miller
Miscellaneous Wisdom
No one really knows whether this is truly the end of an era and the start of an inflationary epoch, but this period is not without historical analogue. The transition from the deflationary 1930s to the inflationary 1940s was caused by World War II, which was also a time of intense supply chain disruptions coupled with huge economic stimulus. The Covid period has some similarities. Immediately following the war there was sharp and severe inflation for several years, which was ultimately brought under control by changes in monetary policy. In the longer term, huge investment in industrial capacity and human capital led to a consumer renaissance and low inflation in the 1950s.
The inflationary period of 1966-1980 is also worth studying if we are entering a new inflationary phase. An important takeaway from that period is that a surge in interest rates does not necessarily happen overnight. Instead, it happened in fits and starts over the course of several bear markets and recessions. Stock multiples ended that period in single digits, but the nominal value of the Dow hovered around 1,000 for more than a decade.
We may be entering a period in which the Fed raises interest rates more frequently than it lowers them, but the Fed is still very reluctant to cause a recession. If it looks like higher interest rates are putting employment at risk, the Fed is likely to abruptly change course despite inflation. The result would probably be positive for capital market valuations.
"You can’t think of a worse environment than where we are right now for financial assets..I think we’re in one of those very difficult periods where simply capital preservation is I think the most important thing we can strive for. I don’t know if it’s going to be one of those periods where you’re actually trying to make money." - Tudor Investment Corporation Co-Founder Paul Tudor Jones