Walmart’s security premium | USAEMALL.com

Good Morning. Quiet in the market today . . . too quiet. After a crazy ride last week, and with big earnings reports and economic indicators in the coming days, is this just the eye of the storm? Send us your thoughts and meditation practices: [email protected] and [email protected].

This Wednesday at noon UK time and 7am eastern time I (Rob) will be joining FT experts from New York, London and Tokyo for an FT subscriber event about the recent surge in market volatility. I plan to stir things up as much as I can. I hope Unhedged readers will join us. Register for your subscriber pass and submit questions for the panel at ft.com/marketswebinar.  

Walmart and the high price of safety

Walmart and Alphabet make an interesting financial comparison. This sounds a bit random, and maybe it is. But stick with us.

Alphabet is fast-growing and super profitable. In the past five years, its revenue has grown at an 18 per cent compound rate, and its average return on equity has been 24 per cent. Walmart grows at about twice the rate of GDP and is solidly profitable, with revenue compounding at 5 per cent and an average ROE of 16 per cent.

The reason for the differences is obvious enough. Alphabet runs an internet search monopoly and has an iron grip on the online advertising market; it’s a relatively capital light business (or was before the AI data centre wars broke out). Walmart is the strongest player in an ancient, capital intensive and hyper-competitive industry. The surprise, if any, is that the growth and profitability gaps aren’t wider.

The comparison is superfluous inasmuch as the two are in different industries. But the shares of each do compete as options for investors shopping for megacap US stocks. Both are huge, liquid and closely followed stocks owned by lots of generalist global investors.

The punchline here is that the faster growing, more profitable oligopolist is a significantly cheaper buy for those investors. Walmart trades at 28 times this year’s expected earnings, Alphabet at 21. To put it somewhat differently, a dollar of Walmart’s earnings cost an investor almost 40 per cent more than a dollar of Google’s.

In the abstract this is odd, because P/E ratios should rise with growth rates and ROEs. Common-sensically, though, we all know what is going on here. Walmart is a much safer business than Alphabet. Weird things happen in tech (Might AI upend the search industry? Might online advertising demand falter?), but people will always need cheap groceries and clothes. What is more, Walmart has proven that, however tough a business it is in, it has enduring advantages. The shares have done well recently, as Greg Melich of Evercore ISI pointed out to me, because the company’s 10-year long investments in lower prices and better infrastructure are now paying off. Customer traffic is rising and the online business generated $30bn in revenue last year. In Melich’s view, Walmart has successfully made its US stores double as efficient as the local distribution centres of its online competitors, including Amazon, who will now struggle to beat Walmart in many product categories.

One might think of the valuation gap between Walmart and Alphabet as a very rough proxy for how much equity investors are willing to pay for safety. The chart below shows that the Walmart valuation premium rose sharply early in the pandemic, and did so again in 2022 as inflation rose and higher rates loomed. In recent weeks the premium has shot up again as Alphabet has sold off:

Whatever index levels or volatility indices are telling you, there is still a lot of fear in the market. 

Bank of Mexico’s tough decision

In this past rate cycle, emerging market central banks consistently beat their advanced economy counterparts to the punch. And no emerging market is closer to the US than Mexico. As the US’s largest trading partner, Mexico can be seen as the tail of the US economy: ripples here become shocks there. So Bank of Mexico (Banxico) policy decisions often serve as a reliable indicator of where the Federal Reserve may go next.

Last Thursday, Banxico faced a tough decision. Mexico’s economy has been slowing rapidly, in part due to flagging US consumption. And our southern neighbour found itself in the crosshairs of last week’s market rout. The Mexican peso, a favourite target for the yen carry trade, accelerated its downward trend, stoking fears of inflation. The IPC, Mexico’s already weak equity index, also fell. Both the currency and the index recovered lost ground in the following days, but there was a much higher than expected inflation reading on Thursday morning.

Investors started paring back their expectations for an interest rate cut. From Kimberley Sperrfechter at Capital Economics:

It all [made] Banxico’s decision more difficult. There [were] factors in favour of a cut, and factors in favour for a hold. What [will be most] revealing from the choice is how they are feeling about the Mexican and US economies, and the market. There has been weakness, emphasised in Banxico’s past communications . . . But inflation is likely to rise over the coming months.

Did fears of an economic slowdown and subdued US consumption warrant a rate cut? Or did concerns over inflation, the peso and market volatility require hawkishness?

By just a hair’s breadth, Banxico chose to prioritise growth. In a 3-2 vote, Mexico cut its rate by 25 basis points. In its communique, it acknowledged that inflation would persist and suggested it might adjust its reference inflation rate. But the emphasis was squarely on the wavering Mexican economy and, by extension, slowing US demand.

Banxico, with responsibility for a more volatile economy, has reason to worry more, and act more quickly, than the Fed. That it proved to be more worried about growth than inflation at a tricky moment says something important about the balance of risks in North America.

(Reiter)

Margin debt

The violent moves in markets last week suggested that some investors may be overleveraged. But what kind of leverage?

Finra, the brokerage industry’s self-regulatory body, tracks the dollar amount of leverage in clients’ accounts. It’s definitely up in nominal terms:

But interestingly, the ratio of customer account leverage to GDP has been flat since 2008, and both the ratio to GDP and the ratio to overall market capitalisation have been generally declining since 2018 (with the exception of a Covid spike):

It is important to note that this is just one corner of the leverage universe; as we saw with the carry trade, there are many other routes for investors, households and traders to pile on leverage. But if the market is indeed overleveraged, margin debt does not appear to be the problem.

(Armstrong and Reiter)

One Good Read

Sardines.

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