The past month was a curious one indeed, with little in the way of notable news or events to speak of. However, this did not stop the financial markets from experiencing a flurry of activity, particularly in the world of stocks. Investors were quick to jump on any fluctuations in sentiment, causing the bulls and bears to engage in a seemingly endless cycle of triumph and defeat. If anything, it was a vivid reminder that, sometimes, even the smallest shifts in sentiment can have a powerful impact on the direction of the markets. As always, investors would do well to keep a close eye on these shifts and be prepared for whatever the future may hold.

In the US, the labor market weakened a little, showing an uptick both in initial and continuing claims. However, this data confirmed the direction the market is taking, but it shows no crack yet. Unless we start to see the initial claims printing above 240K-250K consistently, we shouldn’t consider it very meaningful in terms of monetary policy impact. Furthermore, despite the high numbers we got in the first half of April, the unemployment rate is still at 3.5%, which is historically low.

Unemployment rate in the United States, FRED

At the same time, despite headline numbers softening up a little, core inflation is still hot, and Michigan 1-year inflation expectations went up from 3.7% to 4.6% on the data release. The problem about inflation is that it is partially driven by what the population expects inflation to be: in other words, as Richard Excell said in his newsletter, once the expectation of a price level sets in, it changes behavior.

We saw concerning news about inflation in the PMI report as well, which fades every remaining little hope of a pause in May’s FOMC. By reading it, it becomes reasonable to expect higher prints both for CPI and PPI in May:

“The increase in output was the third in as many months. The faster rise in activity was broad-based, with service sector firms registering the sharper rate of growth. Where a rise in activity was noted, firms linked this to greater customer confidence and a stronger uptick in new orders. Some companies also noted that an improvement in their ability to hire staff had boosted output. […] Following back-to-back months of softening cost pressures in February and March, April data indicated a pick-up in rates of input cost and output charge inflation. Operating expenses rose at a marked and historically elevated pace that was the steepest for three months. Hikes in supplier prices were often attributed to greater incremental increases in material costs during the month. Manufacturers and service providers alike recorded sharper increases in cost burdens. Meanwhile, overall output prices rose at the fastest pace for seven months. Firms stated that more accommodative demand conditions allowed them to continue passing through higher interest rates, staff wages, utility bills and material costs to clients.”

You can find the full US PMI report here.

Last week we had the PCE release as well, and it confirmed what was already said in the PMI report: PCE came in line with expectations, although it’s still too high relative to the Fed’s target, and both the Employment Cost Index and the Personal Income surprised higher, suggesting wage adjustments are underway.

Both the labor market data and the inflation data we had this month make the argument for ongoing increases in rate hikes stronger: indeed, as I said multiple times this month on Twitter, as well as in the last portfolio update, we have at least 50bps in more hikes before pausing becomes an actual possibility. In other words, with the current information I expect at least 25bps hikes both on May 3rd and June 14th.

One of the last paragraphs of my portfolio update for March.

For the ones willing to trade the SOFR market, this situation creates some interesting opportunities. At the time of writing this article, meaning April 30th, not only the market hasn’t yet fully priced out a pause for next week’s FOMC (16.1% probabilities of no hike), but it also assigns more than 70% probability that between now and June the Federal Funds Rate won’t increase by more than 25bps. In other words, if you expect like me 25bps hike both in May and in June, you are betting on that little 26.8% probability to become 100%.

I stand by the belief we won’t see any cuts this year unless we get some crisis (and the banking crisis we had wasn’t such), and that at most we will see the Fed pausing. However, the fact rate traders, who are way more skilled in macroeconomics than I am, keep insisting on pricing in cuts by the end of the year makes me think they see something I don’t. For this reason, I’m relaxing the conviction I have in that view.

Equities

With that said, it’s very easy to see why many, me included, are bearish equities. Furthermore, last week Bridgewater published an article titled “The Tightening Cycle Is Beginning to Bite” (you can read it here) in which they put it down perfectly.

However, as it has been very clear over the last few sessions, the stock market is extremely resilient, and it seems like a selloff will never come. There are a number of reasons why it’s continuing to climb up higher despite the weakening fundamentals, from liquidity expansion to positioning to options, but ultimately none of that matters: an analysis is only as good as the money you can make off it, and bears have lost the battle so far this year.

To further add to the bear thesis, the breadth in the market has been terrible this year and that’s clearly visible by looking at the ratio between the Nasdaq and its equal-weighted version. In addition to this, the weighting of the top companies in the S&P 500 has reached new highs, with the top 10 companies now weighting 28.7% alone. In other words, the market is propped up by just a few names, and history shows this condition isn’t really indicative of strong future performance.

One might point out that earnings weren’t that bad after all, and indeed out of the 267 companies of the S&P 500 that reported already, most of them have surprised higher, although the bar was set pretty low anyway: indeed, the consensus was for earnings to fall roughly 7% YoY, which so far isn’t showing. This is good news for bulls. However, the companies that beat are getting rewarded less than the average on the session following the results relative to the performance of the index (40bps vs 100bps average), and the ones that instead miss are getting punished way more than the average (290bps vs 211bps average): this is good news for the bears.

The positioning is stretched long as well, but given buybacks will start hitting the tape again in just two weeks and that we have the August 2022 gap to fill on SPX (which is just 1.40% from Friday’s close), I guess the path of least resistance this week will be higher. At least until the FOMC. Apple reports its numbers the day after, and whatever move occurred in the stock market could be easily undone due to people’s response to such earnings.

Earnings

For the first time in my portfolio updates, I’ve decided to add a section dedicated to my comments on what happened to the companies I follow. In an environment where many traders look just at the revenue and EPS instead of looking at the overall picture, I think it may come out as useful to my readers: if that’s the case, I’ll continue doing it in the future updates as well.

Blackstone

The interesting thing about Blackstone is that thanks to its portfolio, that comprises several asset classes and different countries, the company can see the changes in the economy before they get reflected in the official data. This is a big advantage, as it allows Blackstone to position itself to benefit the most from any kind of economic environment.

The call opened with the CEO Schwarzman highlighting that despite the S&P 500 posted gains for the quarter, they were concentrated in a handful of name and the median stock has been flat on the quarter instead.

The management addressed concerns about BREIT, their real estate division. They explained that BREIT is not as risky as banks because Blackstone has a balanced balance sheet which avoids the asset/liability mismatch that often causes problems for banks. Unlike in 2007 when traditional US offices made up over 60% of its portfolio, BREIT now has less than 2% invested in this sector, which has faced numerous challenges in recent years. Instead, BREIT has focused on thriving sectors like logistics, which now accounts for 40% of its portfolio, up from 0% in 2007. As a result, management expects a robust 9% growth in cash flows year-over-year.

Although BREIT reportedly outperformed the real estate indices, I would take that statement with caution as Blackstone has a wide degree of freedom when it comes to assessing the value of its assets: marks become real only the moment you have to liquidate at that price, but BREIT has been gated a while ago already and every month it hits the redemption limit.

Moving to their credit division, of course higher yields moved capital in these markets, but the management is moving its focus into positioning for the potential to higher defaults in an economic downturn, although the default rate on Blackstone’s non-investment grade loans is still less than 1%.

In any case, the AUM rose to $991 billion, getting near to the trillion goal set by Schwarzman last year. Overall, not a bad quarter. I’d suggest you reading the transcript of the call, as there are some interesting takes on what the market is pricing in and where they see monetary policy going.

Alphabet

Alphabet’s latest results revealed an unexpected detail about the profitability of Google Cloud. However, this was mainly due to a recent shift in their cost accounting methods. Google Cloud’s position in the competitive cloud market improved, according to CEO Sundar Pichai:

“Our growth has come from our deep relationships with large enterprises, a strong partner ecosystem and our product leadership. Over the past three years, GCP’s annual deal volume has grown nearly 500%, with large deals over $250 million growing more than 300%. Nearly 60% of the world’s 1,000 largest companies are Google Cloud customers and many leading startups and millions of small and medium enterprises use Google Cloud.”

Keeping in mind that Google Cloud came after both Amazon’s AWS and Microsoft’s Azure, this is a big achievement.

The Google Advertising segment has only increased revenues by 2%, reflecting the fact that companies are reducing their advertising expenses. During the last economic downturn, Alphabet was immune to this decline in demand because digital advertising was much cheaper than traditional advertising, which instead suffered a lot. However, now that digital advertising represents a significant portion of overall marketing expenses, this is no longer the case.

When it comes to AI, I believe that Alphabet is the top choice to invest in. This is because they own Deepmind, and Google’s business model has always relied on powerful machine learning algorithms: without these, they would not be able to effectively target their ads.

I bought shares at $94 and sold them at $106 before the earnings, to avoid any inconvenience. I am considering buying more shares at a later time, but I believe I can do so at a lower price of around $80 to $85, so I’ll wait for that to happen.

Microsoft

When looking at smaller companies, I usually pay attention to whether they’ve beaten their earnings expectations: that’s because smaller companies can often grow their revenues simply by acquiring new businesses. However, when it comes to bigger companies, they tend to have more room to cut expenses, so I focus more on whether they’ve beaten revenue expectations. In the case of Microsoft, not only did they beat revenue estimates by almost 4%, but they also showed a 10% increase in revenue compared to the same period last year.

Considering the market reacted to these results by driving shares up 7% on the session after the results, and more than 11% overall by the end the week, I’ll go a bit more into details here.

The management’s focus has shifted towards AI, which is similar to how it was all about the metaverse in late 2021 or the cloud a few years before. Don’t get me wrong, I love companies that are able to keep up with the times, and investing in the cloud was indeed a profitable choice. However, it seems like Microsoft’s PR team is trying to make the company appear as a pioneer of every trend on Wall Street just to stay relevant. Citing the words of the CEO Satya Nadella during the call: “The world’s most advanced AI models are coming together with the world’s most universal user interface – natural language – to create a new era of computing.”

Looking at the segments, More Personal Computing, which comprises Windows, Devices (Surface), Gaming, and Search and News (basically Bing), saw revenues fall by 9%. Windows and Devices alone fell by almost 30%. Although Microsoft has clearly focused more on the Productivity and Business Processes, and Intelligent Cloud segments, but the stickiness and reliability of More Personal Computing makes keeping an eye on the developments in this segment crucial.

Moving to the cloud, the market went into this conference worried about a possible slowdown of Azure after last quarter’s results, and despite the celebratory reaction these concerns were justified. To be fair, Azure actually did worse in Q3 than it did in Q2, growing 27% YoY compared to the 31% YoY it showed in Q2.

Then we have free cash flow, one of the most important metrics to evaluate companies, that declined by 11% YoY: while it’s still enough to pay dividends, the decline is significant and cannot be ignored. At the same time, Microsoft added $11 billion to its cash and cash equivalent account, and it’s now in the same position Apple was a few years ago: too much money, and not enough plans on how to spend it. Either they will increase buybacks, or increase dividends.

Visa

I missed the chance to invest in Visa at a good price, even though it was one of the companies I was interested in. I am interested in Visa and Mastercard because these companies are highly defensive: they perform well both in times of economic growth and in times of economic uncertainty. Indeed, they generate revenue from transaction fees rather than taking a percentage of the transaction volume. Even during an economic slowdown, consumers are more likely to trade down than to stop spending altogether, which helps maintain transaction volume.

As a consequence, revenues increased by 11% and the earnings by 17%. This led to an impressive net income margin of 53%, which is especially noteworthy considering the company’s size. The revenue growth was mainly due to international transactions, which increased by 24%, and operating expenses also increased by 11%, driven primarily by higher personnel expenses, which is kind of surprising considering many companies are instead cutting staff.

Positions

My current portfolio allocation is pretty boring, and my operations have basically become just intras and hedging.

Longs: FPI, SJIM
Shorts: NVDA, AAPL
Cash roughly 80%, most of it in US dollars.

Portfolio Update – April 2023