Stone's Weekly Market Guide - Week of August 10, 2020
Chart of the Week: Berkshire Hathaway (BRK/A, BRK/B) reported quarterly earnings which are very interesting because Berkshire can 1) provide a broad look at the economic impacts of the COVID-19 lockdown due to its many operating businesses and; 2) is managed by two of the greatest investors of all time. Full disclosure: Bill Stone is a long-time shareholder of Berkshire Hathaway and worked for Salomon Brothers when Warren Buffett became Chairman and CEO. Berkshire’s quarterly earnings rose sharply but that is just a function the sharp rally in stocks in 2Q, since unrealized gains from their portfolio are included in their earnings. Operating earnings, which removes the distortion from market changes and better reflects the earnings power of the firm, for the quarter declined by -10.2% versus 2019. Weakness in some of the operating units was consistent with expectations given the contraction in economic activity due to the lockdown. Since rail traffic in general was lower in 2Q, Berkshire’s railroad (BNSF) saw “negative impacts on volumes” with earnings declining -15.5% for the current quarter versus 2019. The company noted that “revenues and earnings of most of our manufacturing, service and retailing businesses declined considerably, and in certain instances severely in the second quarter.” Of note was that Berkshire took a $10 billion impairment charge on the Precision Castparts business due to its exposure to the COVID-disrupted aerospace industry. In our previous report about the Berkshire annual meeting, we flagged that Berkshire’s aerospace exposure remained significant despite the sale of their publicly traded airline holdings. On a more positive note, the insurance, utilities and Clayton Homes businesses remained strong. GEICO’s insurance earnings were strong thanks to lower claims due to less driving but will moderate as claims revert and premiums are rebated during the remainder of the year. Berkshire retains a fortress balance sheets with cash rising to $146.6 billion at the end of June from $137.7 billion at the end of March, which provides flexibility to take advantage of opportunities. In addition to the already disclosed purchases of Bank of America (BAC) shares and Dominion’s natural gas transmission and storage businesses, Berkshire bought back a record $5 billion of its own stock in 2Q (see chart) and filings indicate that purchases continued in July. Until an announcement in mid-2018, Berkshire had limited repurchases to when the stock was trading at less than 1.2 times price to book(P/B). While that constraint is now relaxed, it is still a good indicator of the general range when repurchases will likely be seen. Berkshire’s P/B was 1.1 times at the beginning of July and is currently 1.3 times (see chart). After trailing the S&P 500 for most of the year, Berkshire has outperformed by a wide margin since early July. Like other large money managers, Berkshire will disclose more details about their stock portfolio holdings on Friday via their 13F filing.
Week in Preview
· Geopolitical: With lockdown measures being re-introduced in parts of the U.S. and globe to combat a resurgence in COVID-19 infections, the impact on economic activity will be closely monitored. Tensions between the U.S. and China continue with TikTok and WeChat as targets of animosity between the two countries.
· U.S.: Attention will continue to be on negotiations over the next fiscal stimulus package. With talks at a stalemate and the additional $600 per week unemployment benefit having expired at the end of July, President Trump signed an executive order to provide some temporary relief. While this move by Trump may lead to legal challenges, politically it puts pressure on Congress to reach a deal. Headline retail sales for July should slow to 1.9% month-over-month (M/M) from the hefty 7.5% gain in June. Atlanta and NY Fed’s estimates of 3Q GDP are 20.5% and 14.6%, respectively. As we expected, the July jobs report confirmed the loss of some momentum with less jobs created than in June but with the direction remaining positive. Readings for our U.S. Reopening Monitor improved last week showing the uptick in infections that began in June likely peaking. Initial readings on new COVID-19 cases have now fallen on a week-over-week (W/W) basis for three weeks in a row and improvement is showing up in the underlying high frequency economic data for dining and public transit usage. We will be looking for continued progress in economic momentum over the coming weeks. Please see our weekly U.S. Reopening Monitor and our Guide to the U.S. Reopening Monitorfor more details.
· S&P 500 2Q Earnings Season: 2Q earnings season is coming to an end with only 12 S&P 500 companies reporting. According to FactSet, 83% and 64% have beaten consensus earnings and revenue estimates respectively with 63% of companies reporting. If it holds, the reading of 83% beating earnings would be the highest since FactSet started tracking the metric in 2008. The 2Q blended (actual and estimates) earnings decline improved to -33.8% year-over-year (Y/Y) from -35.7% due to positive surprises from multiple sectors led by healthcare and communication services. As we forecasted, some companies have reinstated earnings guidance which is a positive in removing some unknowns. The calendar year 2020 earnings estimates improved to -19.0% Y/Y with 2021 estimates at +28.6% Y/Y.
· Europe: The August ZEW expectations survey for the Eurozone and in particular Germany will be watched closely for signs that the recent increase in infections in Europe could be weighing on economic momentum. The U.K. is also seeing regional lockdowns due to rising infections and are expected to report 2Q GDP at -20.5% quarter-over-quarter. Like the U.S. and the rest of Europe, the 2Q economic decline in the U.K. should mark the economic nadir with just the speed and strength of the 3Q bounce in question.
· Asia: The July China producer (PPI) and consumer (CPI) inflation rose to -2.4% and 2.7% Y/Y from -3.0% and 2.5%, respectively. China also reports July industrial production, retail sales and loans. Japan is closed Monday for the Mountain Day holiday. The Japan June tertiary industry index is expected to rise 6.6% M/M, which would be the first increase since January.
Central Banks: The central banks of Uganda, New Zealand, Belarus, Serbia, Mexico, Peru and Egypt are scheduled to meet with Mexico expected to lower its policy rate.
Week in Review
· Stocks rose by 2.5% for the S&P 500 with all eleven sectors higher for the week. U.S. economic data was supportive with better than expected July ISM readings and job growth, plus 2Q earning continued to outperform expectations. Industrials (4.8%), financials (3.3%) and energy (3.1%) outperformed the S&P 500, while real estate (0.7%), healthcare (0.9%) and utilities (1.0%) were the biggest laggards. WTI (2.4%) and Brent (2.5%) oil were higher with MLPs (4.3%) and the energy sector (3.1%) outperforming. Small cap stocks outperformed the S&P 500 with the Russell 2000 higher by 6.0% with small cap value stocks gaining 6.6%. The 10-year and 30-year U.S. Treasury yield were higher at 0.56% and 1.23% respectively.
· High yield credit spreads narrowed reflecting increased risk appetite. AAA municipal bond yields as a percentage of Treasuries decreased sharply, causing municipal bonds to outperform. The negative revenue impacts of the economic lockdown on local governments and talk of state bankruptcy have driven municipal bond valuations to low levels relative to Treasuries. Allowing states to declare bankruptcy should remain an unlikely outcome with the heart of the issue really about the size and distribution of Federal government aid. Additional support for the states is likely to come in the next stimulus bill.
· The U.S. dollar was stronger against developed and emerging market currencies. Developed international stocks as measured by MSCI EAFE underperformed the S&P 500 returns in U.S. dollar terms (1.9%) and on a hedged-currency basis (2.2%). Emerging market stocks underperformed the S&P 500 with the non-hedged return of 1.0% for MSCI EM.
· The 10-2 yield curve widened slightly to +43 basis points. Another curve measure of three-month yield six quarters forward minus the current three-month yield rose to +4 basis points. The yield curve has historically provided an accurate forecast of future recessions when the difference in these measures turns negative, also known as inversion. Yield curves are one of the major indicators that we monitor to judge recession risk, but these inversions typically happen more than a year in advance of an economic recession but external shocks like the current coronavirus-induced recession might not be accompanied by one. Stocks have historically had significant advances post-inversion.
The PDF version of Stone's Weekly Market Guide is linked here.
The Guide to the U.S. Reopening Monitor is linked here.
The weekly update to the U.S. Reopening Monitor is linked here.
Bill Stone appeared on CNBC's Worldwide Exchange last week and spoke about the large market divergences similar to what we saw in the late 1990s. You can watch it here.