Happy Sunday.
At Rate of Return — we’re always looking for a new indicator or sign of where things are going. This doesn’t mean that they are perfect predictors, or that they should be the entire thesis of any investment approach.
The latest reminder is about credit tightening.
Citigroup expects that an easing demand for commercial & industrial loans — paired with US regulators forcing big banks to hike their capital buffers by billions of dollars for lending — will shave -2% off the U.S. GDP by the end of next year.
“Any knock to the economy from credit tightening would be clearly painful for the slew of companies that have built up a mountain of debt in the easy-money years and are now facing soaring borrowing costs. Issuers have responded by making larger payments on their commercial loans, Bank of America Corp. CFO Alastair Borthwick said on a call with analysts earlier this month.”
“Thus, recession or no recession, we think the probability of higher-for-longer interest rates is far greater than the likelihood of near-term cuts. Therefore, we believe leveraged finance markets are likely to experience higher default rates going forward even if the economy avoids a recession. Capital structures prevalent at companies today were put in place when interest rates were near zero and access to financing was taken for granted. As elevated interest rates make their way through the global financial system – which has racked up over $12 trillion in low-rated debt – the asset bubbles created during the easy money era could deflate painfully, causing a rash of downgrades, distress, and, eventually — defaults.”
OK, so what’s the takeaway then?
Well — the market doesn’t currently project that credit burdens will impact the economy all that negatively + the market is expecting 5 rate cuts next year + the market is expecting +12% earnings growth next year.
“Recession” or “No Recession” — it just feels like all of those assumptions coming true is quite a bold prediction. The bond market, the stock market, and the Fed now all believe that a “Soft Landing” is the most likely outcome.
Maybe that’s correct (and it absolutely could be!). However… 1) the labor market has yet to loosen, 2) inflation has not been beaten despite what many headlines suggest, 3) the gap between workplace productivity & wage growth is massive, 4) $1.7+ trillion of student loan debt is about to need payments toward it again, 5) the yield curve remains firmly inverted, and 6) there’s still a war going on that the U.S. has substantially inserted itself into.
We don’t know what’s to come — but it feels like the recent performance of the stock market has people thinking that the “No Landing / Soft Landing” is taking place right now or already took place. We can assure you that we are still in the early innings for a lot of the different trends above.
The market is on a historic run and there’s obviously plenty to be bullish about. However — we believe that credit event could be the first thing that changes sentiment entirely.
What does that look like? It’s hard to say. Very few people in the US could have predicted the collapse of Silicon Valley Bank (SVB) and First Republic Bank (FRC). In retrospect though — it all looks utterly absurd that a red flag was never raised over the bank’s shortsighted investments. It makes you wonder how many other red flags could be getting raised right now — but are not.
The above charts show that credit markets do not yet properly reflect what’s happening in reality — soaring bankruptcies and unemployment claims creeping up.
$6.3 trillion of outstanding high-yield and investment-grade corporate bonds are also due / coming due by the end of 2025…
“High-profile financial advisers including Houlihan Lokey Inc., Lazard Ltd. and Evercore Inc. say they’re experiencing a surge in enquiries for so-called liability management as corporates bloated with debt find themselves searching for solutions to the end of a decade of almost free money.” — Neil Callanan & Abhinav Ramnarayan, Bloomberg
The full effects of extremely tight financial conditions have not been felt to their full extent yet. There is always a lag.
The future is unpredictable, but if there’s going to be an area that sees the next crack — our bets are on a credit event of some sort.
Portfolio Updates:
Earnings season is in full swing, and I believe the portfolio is very well positioned to benefit. We saw an incredible reports earlier this week from both Google and Meta — two sizable positions in the portfolio — as well as from Tractor Supply Company and Union Pacific Corporation.
However, all the glitter is not gold. I definitely was set back by the Crocs earnings report — despite the solid report for Q2, their revenue forecasts for Q3 were below consensus estimates causing their stock price to fall.
And most notably, Chainlink’s (LINK) CCIP announcement continues to gain traction and momentum — propelling their cryptocurrency higher. Here’s an incredible Twitter thread breaking down the problem they’re solving, who they’re solving it with, and why it’s so important.
I’m eager to continue accumulating more and more of the names inside of my Portfolio Tracker over the coming weeks. We’re still in a clear “uptrend” and I have no intentions of fighting that.
If you’d like to use the same portfolio analysis tool that I use (StockUnlock), click here.
Week in Review — Too Long, Didn’t Read:
Google dominates, Microsoft has some AI-proving to do, Meta seems fairly valued, the IMF raised its global growth forecast, Grayscale is furious that it will likely get leapfrogged for the first Bitcoin ETF, US GDP looks brighter than expected, Core PCE comes in cooler than expected, and Consumer Confidence is improving.
Key Earnings Announcements:
$28B+ in operating cash flow, AI needs to move the needle, and Meta is now pouring on the gasoline.
Alphabet (GOOGL)
Key Metrics
Revenue: $74.6 billion, an increase of +7% YoY
Operating Income: $21.8 billion, an increase of +29% YoY
Profits: $18.3 billion, an increase of +15% YoY
Earnings Release Callout
“Our financial results reflect continued resilience in Search, with an acceleration of revenue growth in both Search and YouTube, as well as momentum in Cloud.
We continue investing for growth, while prioritizing our efforts to durably reengineer our cost base company-wide and create capacity to deliver sustainable value for the long term.”
My Takeaway
What an incredible quarter! I’ve been preaching this name for months now — especially on TikTok, dating back to December here.
Operating cash flow has been the name of the game for this company for most of its history, and this quarter they reported $28.6B of it — beyond the $25.4B the above-linked video was projecting.
Everything seemed to go right for Google during the quarter — Search revenue grew by +5%, above the Street’s 4% expectations. YouTube revenue accelerated by +7%, compared to the -3% contraction experienced last quarter. Cloud revenue was $8B, above the $7.8B the Street expected — while operating at a profit!
But what would a Big Tech earnings call be without the mention of AI? On the call, management emphasized plans to further enhance Search with new large language models (Palm 2, Gemini) — allowing them to make search more intuitive.
Google stock is up some +50% since that above-linked TikTok video — is it still a good buy at $130 / share? Absolutely! Despite the company no longer being “criminally” undervalued, their operating cash flow is projected to continue climbing higher in the coming years (blue line below).
I’m absolutely going to continue dollar cost averaging into this name. Google and Tesla make up my largest “Big Tech” positions in my portfolio.
Microsoft (MSFT)
Key Metrics
Revenue: $56.2 billion, an increase of +8% YoY
Operating Income: $24.3 billion, an increase of +18% YoY