Safety cushion under stocks

Stock markets have started a busy week of results with cautious steps. Nasdaq Helsinki is starting to be at levels last seen in the COVID hole and before that in 2019 and 2015. Perhaps a little breath of fresh air would be welcome for rotten stock portfolios.

Let’s start with a few anecdotal remarks on the direction of the stock market. 

Kempower was the last of the Rocket Mohicans on Nasdaq Helsinki. The sharp fall in recent weeks has almost halved this gravity-threatening stock.

Price reactions seem to be getting more and more violent. For example, Nokian Tyres fell 15% on the profit warning for the current year, although investors' focus was supposed to be on the Romanian factory's ramp-up at some point over the years. Revenio, once considered the king of the Helsinki Stock Exchange, also plummeted 15% on the earnings announcement, although the stock recovered during the day. 

What I'm getting at is that there are signs of a fiercer phase of the down market, where investors are starting to really sell their stocks like no tomorrow. Which, of course, may also indicate that the end of it is near for Nasdaq Helsinki. Maybe.

Let's talk in this post about how the European economy is teetering on the brink of recession. Naturally, this weighs on the outlook for Finnish companies. Then, we take a quick look at the earnings season of the mega-techs before moving on to the main topic: the improving liquidity situation in the global economy. That should support equities at some point.

European economy on the brink of recession

Europe is the largest market for Helsinki Stock Exchange companies and recent economic data shows that the eurozone's flirtation with recession continues. Although the ECB's official forecasts expect the eurozone to avoid a recession by the skin of its teeth, a recession would not be surprising in the light of the news flow.

Neither households nor businesses in the eurozone have an appetite for loans anymore. On an annual basis, the pace of borrowing in both sectors is heading towards zero, as tends to happen in recessions. Debt is money and these statistics tell the same story as the fall in the money supply in the eurozone. If inflation is a monetary phenomenon, one would expect inflation to lose momentum soon. At least the economic strength has gone. 

German business confidence in the economy improved marginally in October, according to a survey by the Ifo Institute. Sentiment improved for the first time in six months but remains poor. Manufacturing is in a bind and orders are low, but companies are still more optimistic about the future. The situation is still brighter in the services sector. Germany is Finland's most important business partner and better news for German companies would be welcome here too. This juxtaposition between Nasdaq Helsinki and the Ifo Confidence Index is a bit of a graph crime, but roughly speaking it highlights the spillover of the weak economic performance of Europe's largest economy to several Finnish listed companies. According to latest data, Germany's GDP fell by 0.1% in the third quarter.

However, purchasing managers' indices for the whole eurozone plunged into the abyss of recession in October, according to preliminary data. The services index fell below 48 and manufacturing remained unchanged at 43. Readings below 50 indicate a fall in activity relative to the previous month, i.e., September. New orders are falling. Companies are reporting lower headcounts for the first time since the pandemic uncertainty in early 2021, although with labor shortages looming it’s unclear whether this is a new trend or a momentary blip. So far, employment has developed well despite the challenges. The attention of companies is to reduce inventory levels. This is also felt by many companies on Nasdaq Helsinki, whose customers reduce new orders when there is too much stock on the shelf in the face of dwindling demand.

Fortunately, weakening demand is easing price pressures, especially in manufacturing. In turn, the service sector continues to show the persistence of wage inflation.

Highlights from the earnings season

The earnings season has progressed handily in the US, the main global market, with mixed results from mega-tech companies.

The mega-techs’ battle for cloud supremacy has intensified. Microsoft (perhaps the highest quality listed company in the world, if I do say so myself) whipped its Azure cloud service into a 29% annual growth rate, capturing shares of the lucrative cloud market. The company explained its success by its customers' interest in AI. Microsoft's cloud services already generate more than USD 100 billion in annual revenue, which is the same as the company's total revenue in 2019.

In contrast, growth in cloud services from rival Alphabet fell short of expectations, which the company explained by customers' cost savings. The current market leader, Amazon's AWS, also grew more slowly. For tech giants, the current AI boom is an important driver. Amazon CEO Andy Jassy said that generative AI, which requires an awful lot of computing power, is an opportunity that’s worth tens of billions for AWS.

Despite mostly good results, even the share prices of the big tech giants have taken a hit recently.

All in all, the market has reacted badly to lower-than-expected results. On average, almost 80% of the 246 S&P 500 companies that have reported their results already have beaten expectations, but still the average price reaction has been negative. For investors, the development is clearly not enough.

The analyst consensus continues to forecast a rapid gallop in earnings to new highs on the back of a strong fourth quarter. As I pointed out in a post before the earnings season, these forecasts are based on the profitability of listed companies improving to near-record levels, despite inflation.

Shares have a safety cushion somewhere far beneath them

 Let's talk about liquidity developments, which have been neglected in the rush of the earnings season. While in principle rising interest rates around the world are tightening monetary conditions, central banks have safety cushions in place for the economy. A major turning point happened a year ago and I've been highlighting it in my posts. The turnaround is reflected in the strength of the S&P500 index and the bounce in speculative asset classes such as gold and Bitcoin over the past 12 months.

Let's start with the world's second largest economy, China. On Tuesday last week, Chinese President and Communist Party General Secretary Xi Jingping visited the headquarters of the country's central bank for the first time in his dictator career. Although the details of the visit are not known, in authoritarian countries, visits by leaders are seen as symbolic gestures of the current focus of attention, which is now understood to be the economy. The Bank of China has injected liquidity into the system and lowered banks' buffer requirements.

At the same time, the administration decided to step up public stimulus and support the ailing economy. Total borrowing has risen sharply recently. Debt limits were changed, which is extremely rare in the middle of a budget period. The measures are a strong signal that the economy in crisis will not be allowed to slip into recession and that growth will be backed by a strong arm to break the deflationary spiral. However, the measures are not drastic, as the central government doesn’t want the debt to balloon out of control. Moreover, the stimulus so far is traditional construction and infrastructure, not household support, which could be a healthier option in the long run. Important long-term economic reforms remain to be seen.

The Chinese stock market has continued to perform poorly, and the recovery hasn’t been reflected in raw material prices, so there is not yet too much enthusiasm for Chinese support measures. But they're still there. 

In Japan, the former number two in the global economy, the central bank has also continued its irregular bond purchases. Inflation is not a terrible problem in Japan, but interest rates are threatening to rise there too. The country's central bank is engaged in so-called “yield curve control”. It will be interesting to see whether the debt-ridden and demographically aged Western countries will eventually end up with similar interest rate controls. If or when public indebtedness does not stop, it’s hard to see a situation where central banks don’t have a hand in solving the financing of sustainability deficits.

The ECB is reducing its balance sheet, but at the same time it is ready to jump in with its various programs to help euro countries like Italy that are being targeted by the market.

 In the UK, the financial center of the past, the Bank of England has also made financial stability a priority. The country's financial system almost sprung a leak a year ago when bond yields, spooked by loose public borrowing, rose too quickly. At best, the central bank is working on a tool to counter such liquidity shocks.

After the fall 2022 event, the main central bank, the US Fed, also quietly changed course. Officially, the Fed's balance sheet continues to shrink at a rapid pace. But if you look at net liquidity, which takes into account the items in the balance sheet that do not support the economy anyway, monetary policy has been kind of stimulating for the last year. In the US, the stock market coincidentally bottomed out at the same time. The improvement in net liquidity is effectively explained by the withdrawal of deposits by investors, such as funds or banks, from the Fed's reverse repo agreements. In layman's terms, it's a parking lot for liquidity at the Fed. While the Fed shrinks its balance at one end, a corresponding amount of dough is released into the system when this parking lot is emptied.

The interesting question is what happens when this cash parking space is empty.  

In the bond market, interest rates have risen sharply as the federal government is borrowing at a record pace. There’s a bond supply of billions as investors demand more interest income. If the Fed's net liquidity were really to turn down, the tightening monetary policy of reducing the balance sheet and raising interest rates together could strangle the economy too much. Liquidity commentators like Michael Howell have been arguing for a year how central banks like the Fed use liquidity to hold the system together, while interest rates can be used to beat inflation. The Fed may soon be facing a backlash over its balance sheet measures if the economy starts to rattle. So far, the Fed's comments have pointed to the importance of reducing the balance sheet, so only time will tell what will happen to monetary policy.

Furthermore, monetary policy also takes time to feed through to the economy. The Fed started raising interest rates in spring 2022. The gnawing effect of high interest rates should start to show up in the economy. In this sense, too, the balance sheet reduction measures will soon face a headwind. Globally, equities are already partly supported by central bank support, even if it’s not felt here on Nasdaq Helsinki.

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