Bankruptcy rates at financial crisis levels

Stock markets have started the new week with caution.

In this post, let’s about the recent inflation data that is weighing on stocks. Next, we’ll look at bankruptcy rates of Finnish companies. This is followed by a brief commentary on the impact of the Middle East conflict on the global economy and finally some observations on the start of the US earnings season.

Across the pond, the earnings season has already taken off properly with the big banks. This week, Finnish investors' thirst for information will also be satisfied by the Q3 results of Nokia and Nordea, among others. Those results on Thursday are also the reason why this post is unfortunately the only one this week.

Inflation is entrenched in the economy

Let's talk about inflation with recent data from the US, China, and Finland.

Starting on the other side of the Atlantic, annual inflation in the US was above expectations in September. The official inflation rate was 3.7%. Since inflation is a big problem, it’s fashionable to break its examination into fancy foofaraw. Core inflation for services excluding slowly updating shelter costs was 3.9% per year and as much as 0.6% per month. Monthly inflation averaged less than 0.2% before the pandemic while it has averaged 0.4% in recent years, illustrating the problem of sticky inflation.



This indicator, known as supercore inflation, is good in the sense that it better reflects the evolution of slowly changing prices in the economy. This measure is also considered the Fed's favorite, so the indication of inflation resilience doesn't give much reason to expect rate cuts in the near future. Market expectations for the level of the Fed policy rate have risen further into the future. Compared with early September, the Fed policy rate is now expected to be 4% in three years' time, compared with 3.5% just over a month ago.

I also came across Barclays' observation of how inflation has accelerated in sectors that were largely unaffected by COVID-19. This also supports the view that inflation has had time to grow maddeningly deep roots in the economy.

And that's not all, folks. While for the time being it has made sense to exclude shelter costs from the inflation data because of the collection methodology, at some point the situation should normalize and the official shelter data should be in line with more rapidly updating private statistics such as rent inflation. This graph plots the year-on-year change in the Zillow rental index and the Case Shiller housing price index. Despite an almost 8% rise in mortgage interest rates, housing prices have started to rise again. The rental index appears to be bottoming out but may not cool sufficiently if house prices continue to rise.

The market was not terribly alarmed by these figures. The market therefore seems to have accepted that inflation will remain elevated for longer. It would be a shock for equities if inflation were to start to run rampant again.

In China, the world's second largest economy, the problem is the opposite. There is hardly any inflation. The rise in consumer prices was zero per cent in September. This flirtation with deflation isn’t about the genius of the Chinese pseudo-capitalist-communist command economy, but about the weakness of the Chinese consumer and the country's economic problems. The country's consumer sentiment has remained sour as the real estate sector rots and the country's perverse economic growth model oppresses ordinary consumers.

Bucketloads of stimulus aren't to be expected, but the country is increasing its borrowing for public infrastructure projects. Economists still expect the country to reach 5% economic growth this year, even if it's achieved on debt.

In Finland, inflation in September was 5.5% year-on-year. In Finland, we have a funny way of including, e.g., mortgage interest rates in inflation. Thus, I would rather follow the consumer price index, which is harmonized with the eurozone calculation methods, which rose by 3%. Inflation in Finland is therefore below the 4.3% inflation rate in the eurozone. In practice, the rise in the Finnish price level stopped for the time being last spring.

Inflation in Finland affects the wallets of us Finns and that’s why it's worth following, but of course it doesn't affect the interest rate decisions of the European Central Bank's meetings. Indeed, Finland is awkwardly falling between a rock and a hard place as the nation’s own economy crumbles, while an otherwise surprisingly strong eurozone keeps interest rates high at the ECB. According to recent data from Statistics Finland, the number of bankruptcies in Finland has risen to levels close to those seen during the financial crisis - more than 3,000 a year - although fortunately, in terms of the number of people involved, the figure is lower so far.

Spillover from the Middle East conflict could lead to a global economic downturn

Spillover from the Middle East conflict could, at worst, send the global economy into recession. Bloomberg had a rough idea of how an escalation in the conflict between Israel and the terrorist organization Hamas could affect oil prices and the global economy. There is no oil production in the conflict area, as far as I know, but the possible escalation of the conflict into a more or less direct confrontation with Iran could have an impact on the world economy. Iran has increased its oil production this year as relations with the US have warmed slightly. Further tightening of sanctions would remove oil from the world market.

A direct war between Iran and Israel could push oil prices closer to $150 per barrel, with the current price hovering around $90. That could cut one percentage point from global economic growth, leaving global economic growth below 2%. Since there are still relatively fast-growing economies in the world, such as China, 2% growth would be tantamount to a recession.

These estimates are rough, because no one knows for sure how the war will develop or the multiplier effects of a possible escalation of the war. Mainly, investors should be aware of what a nail in the coffin of the global economy this conflict could become if things were to go south.

Oil prices have fallen after a small bounce. It’s also worth bearing in mind that oil prices are now at roughly the same level as a year ago, so their contribution to annual inflation is negligible, even though I’m cutting a few corners here.

Highlights from the US earnings season

As usual, the results of the major US banks have exceeded analysts' expectations and send a healthy signal about the economy. With a balance sheet of just under $4 trillion, the country's largest bank JP Morgan increased its loan portfolio by 17%. Return on equity was an excellent 22%. Loan loss provisions were set at $1.5 billion, driven by rising credit losses on credit cards. This souring of credit card debt has also been reflected in the New York Fed's statistics. However, the bank said this was more of a return to normal after an unusually low period of losses. Of course, the way to an economic crisis is always through normalization.

This is also well reflected in the loan loss provision data for all banks. Loan loss provisions have averaged a few percentage points of loans, which is still below the pre-pandemic level of 3%.

Jamie Dimon, CEO of JP Morgan, commented that wars around the world and the US federal government's massively stimulative economic policies are increasing the risk of prolonged inflation. The big banks in the US have so far not had to compete for deposits by raising interest rates much, so bank managers are unlikely to mind higher interest rates for longer.

Wells Fargo, formerly Warren Buffett's favorite bank and now mired in scandal, also exceeded analysts' expectations, boosted by interest income. The bank commented that the economy still looks strong, but growth is slowing, which is reflected in weaker loan growth and also an increase in credit card losses. Earlier in September, the bank's CFO commented on how the pain in the souring office property sector seems to be spreading more widely. Small banks in particular have a huge concentration of risk in this sector.

The third reporting major bank, Citi, similarly exceeded expectations.

Share prices of big banks, and especially small banks, have flatlined this year as investors feared a real estate bust and an economic downturn.

Fastenal, a well-positioned fastener wholesaler that is close to the real economic pulse, also exceeded analysts' expectations, which is not unusual in the US. Sales fell by 2% in Q3 but recovered somewhat already in September. Fastenal is an unusually high-quality company. The company is growing reasonably steadily and its ROIC has hovered steadily around 25% for the past 30 years.

Pepsi also reported sweet results. Pepsi is a good example of a company with well-known brands and pricing power. The company's sales volume, i.e., sales of soda and chips, has been declining in recent quarters. But at the same time, the company has been able to easily raise prices by up to 12% year-on-year. As a result, turnover has increased and profitability has been defended in difficult times. Few businesses have this ability to pass on increased costs directly to consumers.

Of course, prices can’t be raised indefinitely and turnover can’t grow without volume growth. The share prices of both Pepsi and its peer Coca-Cola have tumbled to levels not seen many times in the 2000s. This is probably partly due to concerns about consumer resilience and rising interest rates, as many other consumer companies have fallen recently. Pepsi and Coca-Cola are also hit by concerns about the impact of new weight loss drugs on demand.

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