US growth is good, but less good

Good morning. House Speaker Kevin McCarthy is out, throwing a wrench into the US political machine. Good timing for Unhedged: tomorrow we will do the first of three weekly collaborations with the historian Adam Tooze, in which we will discuss what the happenings in Washington mean for markets, and vice versa. In the meantime, we await your emails: [email protected] and [email protected].

When the market looks at the economy, what does it see?

Yesterday we talked about the cautious stock market. One important change is the relative performance of cyclical stocks versus defensives. Cyclicals, after months of outperformance from May through to August, have begun to slip. That fits with a broader picture of investors hedging, fund flows moving towards cash, and deteriorating sentiment.

But why? Growth, last we talked about it, seemed strong. Economic data has consistently surprised to the upside. For a while, “resilience” was the watchword. This remains broadly true, but the picture is changing at the margins. The economy is still surprising to the upside, but the optimistic surprises are shrinking in magnitude. Below is the Citi US economic surprise index (blue line), which captures how economic data performs relative to prior expectations. It is still well into positive-surprise territory, but just less so. That decline coincides with cyclicals’ sloppier performance relative to defensives (pink line):

Markets care about the second derivative, changes in the rate of change. So it’s not surprising that smaller positive growth surprises would weigh on cyclicals.

Growth itself, though, is hard to read right now. Take one simple indicator of US demand growth: real final sales to domestic purchasers, the sum of consumer spending and private investment, ignoring net exports and government spending. This gives a gestalt picture of underlying demand, since it is mostly unaffected by swings in global growth or US policy decisions. In the second quarter it grew 1.3 per cent year over year, a touch sluggish but far from dreadful.

Matthew Luzzetti, chief US economist at Deutsche Bank, points out in a recent note that removing cars, a sector that has been exceptionally volatile recently, casts growth in a harsher light. He says underlying demand is at a level historically consistent with recession. Luzzetti’s chart:

In contrast, the Atlanta Federal Reserve’s much watched GDPNow monitor is far rosier. It is forecasting 4.9 per cent real GDP growth in the third quarter, on the back of a 2.6 per cent increase in consumer spending. GDPNow has looked implausibly high for a while, and most people (including us) suspected it would fall as the quarter went on. It hasn’t happened yet.

Whatever is happening now, the expectation among most analysts is for weaker growth in the fourth quarter, as consumers are weighed down by a laundry list of problems (student loan repayments, $100 oil, strikes, car and credit card loan delinquencies, et al).

We agree that pressure is building on consumers. But consumers have been through worse. A strong labour market offsets many woes. Most indicators of labour market tightness have moved back to 2019 levels, still tight but possibly consistent with 2 per cent inflation. The question now is whether the job market will stabilise or continue its decline, which is probably unknowable. In that sense, markets trading along with marginal surprises in economic data may represent a holding pattern, biding time until the economy becomes less inscrutable. (Ethan Wu)

ESG and valuations

The last time I wrote about ESG, I said I had not seen any good recent studies of the impact of corporate ESG profiles on stock valuations. Duncan Lamont of Schroders responded by sending me one, which he published in late 2022. It’s good, and provides some reason — which is not to say a conclusive reason — for me to soften my scepticism about the ability of ESG to move corporate valuations.

You can read the study yourself, but here are the highlights. Lamont sorts the MSCI All-Country World index into quartiles according to Schroders’ SustainEx model, which measures companies’ impact on society and the environment. Of course, in the SustainEx model, or any other ESG scoring system, high scorers will tend to have higher valuations than low scorers. This is a reflection of sector mix: materials, energy and industrials, for example, tend to be “browner” than technology and also, for completely separate reasons, have lower valuations.

But Lamont makes comparisons within sectors, and finds that the differences between the top and bottom quartiles are pronounced there, too, especially in areas such as energy and materials. His table:

This is a striking result. But there is an important causal question here. Are the higher-scoring companies more richly valued because their businesses happen to be intrinsically ESG-friendly, or because of how they are managed for ESG outcomes, or because of some spurious correlation? For example, coal stocks tend to be cheaper than other kinds of energy stocks, and dirtier too. But are they cheaper because they are dirtier, or because coal is a bad business generally? You almost need to comb through the index on a company by company basis to find the answers. 

But Lamont makes another point that somewhat ameliorates this concern. He shows the ESG valuation premium of various sectors across time. The premiums widened, overall, in 2019-20. His charts for the materials and energy sector:

This is a hopeful sign. It suggests that, perhaps, changing investor preferences for ESG excellence can drive big valuation differences, which could in turn provide management with incentives to change their practices. It would also present investors with a juicy opportunity to invest in companies that have ESG upgrades in their future. But both points will depend on whether the relationship between ESG scores and valuations is persistent and consistent (one academic paper has suggested that the relationship varies a great deal across countries; another finds that periods of ESG outperformance, whether driven by rising valuation or something else, tend to be given back). Lamont promises to update the paper before too long.

Of course, this is not a carefully controlled study: it is basically just a map of correlations. But it is suggestive, and it has left me looking again at other studies of the topic. If you have any favourites, send them along. 

One good read

The American nightmare.