The Weekend Edition # 88

Debt Ceiling talks move the market; Macro - Office Property; Retail Earnings; Fed Data

May 21, 2023

Welcome to another issue of the Weekend Edition. 

Thank you to all who’ve read and welcome to all the new subscribers this week!

Here’s what we cover:

  • Market Recap - Debt Ceiling talks move the market

  • Macro - Office Property

  • Earnings - Retail Earnings

  • The Week Ahead - Economic & Earnings Calendar

  • Closing Thoughts - Fed Data

Let’s dive in ⬇️

Market Recap - 15 May - 19 May, 2023 📉📈

The broad market indices closed up for the week although we saw a pullback on Friday. Big tech is still leading the rally. The markets this week however, seemed to have revolved around the US Debt Ceiling talks. As soon as there seemed to be an agreement, the markets rallied sharply. It would seem however, talks broke down on Friday and now there’s another meeting today, Sunday, to determine further courses of action.

We got the US Retail Sales numbers this week that showed somewhat of a recovery in April, particularly in the General Merchandise category. This was unexpected given that we’re seeing most of the spending data decline in April, particularly after the SNAP payments were discontinued in March.

The good news on the Debt Ceiling front earlier in the week also fueled a risk-off rally with Gold declining sharply to just above $1957 on Thursday before recovering somewhat on Friday.

While spot prices for Natural Gas still remains below $3, we saw a sharp rally during the week as well of over +16% during the week.

Macro - Office Property 🌎

Commercial Real Estate (CRE) has been the subject of much interest in the news lately. With the likelihood of people not wanting to return to work, it would seem that office properties have been taking a hit.

However, the increase in focus started when the US banks began to run in to trouble and people started to look at how much of these office properties are financed.

There have been several high-profile CRE loan defaults and Commercial Mortgage-Backed Securities (CMBS) has seen their delinquency rates rise by 1% over the past 3 months (as of March 2023)1.

What is the state of the of the market? 

According to the latest Q1, 2023 report for the office property market by Cushman & Wakefield:

  • Leasing activity has decline by 23% quarter-on-quarter.

  • Office construction is at its lowest point since 2014 with a pipeline of 79 million square feet.

  • National office vacancy rates have now increased by another 0.60% to 18.6%.

Research from Goldman Sachs and Co-star show that of the office vacancies, Class A properties remain worse off but, newer buildings continue to outperform with larger rent premiums and lower vacancy rates.

As for the state of the debt on these office properties:

  • Banks hold over 50% of the $5.6 trillion of outstanding CRE Debt. 65% of CRE loans are held by banks under $100B in assets, i.e., small banks.

  • Of the $1.1 trillion of debt maturing in 2023 and 2024, office comprises 23% of this debt

  • Over 40% of the CRE debt is floating rate debt

With vacancy rates rising at an alarming rate, offices property owners will find it even more challenging to repay the loans on these properties. Many of the loans will have to be refinanced or restructured at a higher cost. Some of these loans may even go into default and the office properties seized.

The problem with this situation is that with asset values declining drastically, many of these office properties may not even cover the loan amount and there actually may not be buyers out there for these distressed properties. So the banks may be stuck with a bad loan and bad asset.

Some of these office buildings may become “zombie buildings” because property owners don’t have the wherewithal to fill the office building. What’s more is that converting these building to residential properties is now easy feat either. Not only will it cost additional money but, there are zoning issues that may prevent this.

Here’s a great chart from BCG that shows how lower office utilization is a negative, self-reinforcing cycle.2 

Earnings - Highlights 📝

Here’s the FactSet Summary for the Week:

The blended earnings decline for the week improved yet again from -2.5% to -2.2%. We’ve now seen 95% of the S&P500 report and earnings for the first quarter has come out much better than expected. The Estimate in March 2023 was for a -6.7% decline in earnings.

It’s been a busy week for retail earnings, with some of the biggest retailers report this week. Next week, we continue with retail earnings for the rest.

Walmart and Deere were both the stars of the week with significant beats on both revenue and earnings. While Walmart did guide to softer numbers, Deere raised guidance. TJX (the discount store) came in ahead of EPS and revenue estimates but, still remain cautious on discretionary spending. Their inventory levels still remain muted and Home Goods category continued to see a decline of -7% YoY.

Speaking of home goods, Home Depot saw its revenue decline for the first time in 5 years, falling by 4.2% YoY to $37.3B. The figure also missed analysts' expectations by more than $1.0B. They discussed the weather on the West Coast as part of the reason but, they're also definitely seeing a slowdown in home improvement demand and retail sales for big ticket items like appliances and grills. Low’s is expected to have an even tougher quarter, when the report next week.

The biggest decline, however, came from Foot Locker that was down over -25% on Friday. Foot Locker seems to have lost their footing ever since Nike decided to pull back from them. They hired CEO Mary Dillon, the superstar CEO who was responsible for Ulta’s massive growth. Despite this, the company guided EPS of $2.00-2.25, down from $3.35-3.65, and comps to fall 7.5-9.0%, worse than its initial negative 3.5-5.5% forecast. They also announced a new CFO but, the real issue is the retail decline story.

The Week Ahead 📅

Earnings Calendar 

Economic Calendar in Eastern Time

Closing Thoughts - Fed Data

We had an interesting discussion between Fed Chair Powell and former Fed Chair Bernanke on Friday. Most of it was a walk down memory lane, discussing the Fed’s actions, inflation and bank collapses. Chair Powell’s remarks were prepared and measured. Obviously, the Fed Chair has to be very careful about what he says.

Chair Powell did reiterate however, that inflation still remains "far above" the Fed's objective, but also said that rates may not have to rise as much because of credit conditions. This is largely in line with what was said at the FOMC press conference and we will know more when the FOMC minutes come out this Wednesday.

As of the most recent data from the CME Fed Watch Tool, the probability of the Fed pausing rate hikes on 14 June is 82.6%, which is significantly high. However, there are some signs in the US Dollar market and the bond market that is signaling that market participants believe the Fed might consider hiking in June.

We have the PCE inflation numbers coming out on Friday and this one will certainly be important to gauge whether the Fed thinks inflation is moving in the right direction and it is appropriate to pause.

Here’s wishing you safe investing.

Please take a moment to share and subscribe, if you found this newsletter useful.

Sincerely yours,

Ayesha Tariq, CFA

There’s always a story behind the numbers.

None of the above is Investment Advice. I may or may not have positions in any of the stocks or asset classes mentioned. I have no affiliation with any of the companies other than explicitly mentioned.

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