Wall Street Breakfast: What Moved Markets

Investors enjoyed a breather this week from the market’s April-and-May selloff that had taken the Nasdaq Composite solidly into bear territory and the S&P 500 20% below its record high. The Dow Jones index surged 6.2% for the week to snap an eight-week decline, its longest losing streak since 1932, while the S&P climbed 6.5% and the Nasdaq jumped 6.8%, both ending seven-week slides. Much of the week’s gains came Thursday and Friday, as stocks rallied with strong retail earnings and a slowing inflation report sparking hopes entering the three-day weekend that the Federal Reserve’s tightening policy can avoid tipping the U.S. economy into a recession. The question now is whether the market has found a bottom, with the Nasdaq now 25% below its peak, the S&P off 13% and the Dow down 10%.

Windfall tax

The UK introduced a 25% windfall oil and gas tax. Prime Minister Boris Johnson’s Conservative government became the first to put into action an argument that the energy industry has profited too much from a surge in commodity prices that are stoking inflation. About 5 billion pounds is expected to be raised, which will finance a one-time payment of 650 pounds to about 8M of the poorest households.

Statements: “The oil and gas sector is making extraordinary profits,” Chancellor of the Exchequer Rishi Sunak said in Parliament. “Not as the result of recent changes to risk taking or innovation or efficiency, but as the result of surging global commodity prices.”

The tax “sends the wrong signal to the whole sector, against a backdrop of rising business taxation elsewhere,” Rain Newton-Smith, chief economist at the Confederation of British Industry, told the BBC.

How it works: Details of the final legislation remain vague. There will be a sunset clause; however, the clause will be price dependent, with no specified date. There will be an investment tax incentive; however, the incentive appears lower than existing incentives. And there may or may not be a « baseline » profitability measure which determines the quantum of the “windfall » profits. Furthermore, investors are left guessing at exactly who will pay the tax.

The UK has a somewhat complicated tax and royalty regime for North Sea producers. All UK resident companies pay corporate income tax on worldwide pre-tax profits. If BP (BP) earns a profit refining oil in Whiting Indiana, it will pay tax on those profits to the UK Treasury. However, the UK also charges North Sea producers a « ring fence » corporate tax, a « supplementary charge », a « petroleum revenue tax » and a « value added tax. » Deloitte estimates the effective « government take » on pre-tax profits for UK North Sea producers at between 62% and 81%.

And although the Chancellor did not specify who will pay the incremental 25% tax, it’s likely to be imposed on UK producers, rather than UK-domiciled entities alone. That is to say, BP (BP) is unlikely to be charged a windfall tax on profits earned in Indiana, but Total (TTE) will bear the higher rates on UK North Sea production.

Start of a trend? Could the UK’s decision spur movements in other countries for similar taxes? The Wall Street Journal described the decision as “Boris Johnson Goes Bernie Sanders.” Undoubtedly, proponents of windfall taxes will point to a right-wing government embracing such policies as a starting point.

President Joe Biden has called for eliminating tax breaks for oil and fossil fuel companies, but a windfall tax seems remote. While it is a literal Conservative Party, the UK Parliamentary majority has a track record of tax moves that U.S. Republicans would consider as extremely left-wing. In 2011 Tory Chancellor George Osborne put a “supplementary charge” on oil and gas production to the tune of 2 billion pounds.

Energy tax increases “would disincentivize additional production, decrease supply, and subsequently increase energy costs for families at a time of historic inflation and record-high gasoline prices, » Anne Bradbury, CEO of the American Exploration and Production Council, told the Houston Chronicle. « For these reasons, members of both parties have consistently rejected attempts to target energy producers with new taxes and fees.” (90 comments)

Horror in Texas

A mass shooting at the Robb Elementary School in Uvalde, Texas, has rocked the nation. The 18-year-old gunman, Salvador Ramos, shot his grandmother before heading to the school with a handgun and possibly a rifle that he had purchased on his birthday, hinting on social media that « the kids should watch out » ahead of the attack. The gun control debate has resumed following the massacre, with efforts to change any U.S. gun policies waxing and waning in Congress in the years since Sandy Hook.

Statement: « As a nation, we have to ask when in God’s name are we going to stand up to the gun lobby. When in God’s name we do what we all know in our gut needs to be done, » President Biden said in a televised speech. « I am sick and tired of it. We have to act. And don’t tell me we can’t have an impact on this carnage. I spent my career as a senator and vice president working to pass common sense gun laws. We can’t prevent every tragedy, but we know they work and have positive impact. The gun manufacturers spent two decades aggressively marketing assault weapons, which make them the most and largest profit. For God’s sake, we have to have the courage to stand up to the industry. It’s time to turn this pain into action. »

While Democrats have repeatedly tried to enact new gun-control measures, like universal background checks and a renewed assault weapons ban, the restrictions have failed to make their way into legislation. Last year, the House passed a pair of bills to expand background checks on firearms purchases and close the loophole for private and online sales, though it wasn’t able to clear the 60-vote filibuster threshold in the evenly divided Senate. Strong Republican opposition has derailed the measures, saying the laws would do little to prevent most of these tragedies and would compromise the Constitutional right of Americans to bear arms. Instead, they advocate for more security on school grounds and better tools to deal with a growing mental health crisis, as well as arming more law-abiding citizens and preventing guns from getting into the hands of criminals.

On the move: Fear of gun control sent firearm shares higher, among them Smith & Wesson (NASDAQ:SWBI), Sturm, Ruger (NYSE:RGR), Vista Outdoor (NYSE:VSTO), Sportsman’s Warehouse (NASDAQ:SPWH), AMMO (POWW) and Olin Corporation (OLN). (156 comments)

A new framework

Looking to boost its economic profile in Asia and create another counter-balance to China, President Biden has unveiled a new U.S. strategy called the Indo-Pacific Economic Framework. Joining the deal are a dozen initial partners, including Australia, Brunei, India, Indonesia, Japan, Malaysia, New Zealand, the Philippines, Singapore, South Korea, Thailand, and Vietnam. Together, the countries represent 40% of global GDP and « some of the world’s fastest-growing, most dynamic economies. »

Fine print: The IPEF is not structured as a free trade deal, but is rather a framework that is being called a « 21st-century economic arrangement. » As a result, most of its components will likely not have to go through Congress, where there is little appetite for new trade deals. Many still remember the Trans-Pacific Partnership, which was scrapped by the Trump administration, only to see the remaining signatories go on to ratify the agreement (now known as CPTPP) without the United States. China also magnified its influence in the area with the Regional Comprehensive Economic Partnership, which became the largest trade bloc in history after being signed in November 2020.

Exact details of the IPEF have not been scoped out yet, but the deal will focus on four economic pillars: the digital economy, supply chain pledges, clean energy, and tax and anti-corruption. There will be firm commitments that will be enforceable, according to U.S. Commerce Secretary Gina Raimondo, but will steer clear of tariff arrangements and other traditional market opening tools. Those have become toxic in American politics in recent years despite « greater market access » historically serving as a carrot for the U.S. to set stricter labor standards and intellectual property protections.

Commentary: « The United States needs to enhance its economic competitiveness in the region, » said Ali Wyne, senior analyst for Global Macro at Eurasia Group. « Even those countries that have significant and growing apprehensions about China’s foreign policy and strategic objectives appreciate that they cannot meaningfully decouple from its economy over the short term. » (2 comments)

An emboldened Fed

The Federal Reserve minutes of the May meeting gave investors a pretty clear roadmap for the summer. The minutes, out Wednesday afternoon, painted a picture of an FOMC strongly focused on inflation, with rate hikes of 50 basis points in the June and July meetings. But some members also indicated that price pressures may not be getting worse.

Stocks rally: The market appeared to take the minutes as more dovish than hawkish. Half-point hikes were already priced in for the next couple of meetings and there was no mention of 75-basis-point moves that had become the base case for a few Wall Street banks at the end of April.

The S&P 500 (SPY) rose about 1% to finish out the session and S&P futures (SPX) are up again this morning. Treasury yields (SHY) (TBT) (TLT) continue to creep lower today.

Data dependence: « We think that after the July meeting the Fed is likely to become more ‘data dependent’ with regard to rate hikes, which essentially means that the policy path after July will depend upon the trajectory of inflation and progress toward correcting the supply/demand imbalances in the labor market, » BlackRock fixed income strategist Bob Miller said.

There are already signs that the U.S. economy is weakening. Of the last 19 major economic indicators, 13 have missed economists’ expectations, Nomura noted. The question is whether that will bring about a Fed pause, which stock bulls are hoping for, or will it stiffen the central bank’s resolve.

If there are signs of falling inflation and improved labor market imbalances « the Fed gains some breathing room and can shift policy adjustments to 25 bps increments, while still pursuing something in the estimated range of neutral, » Miller said.

Pantheon Macro economist Ian Shepherdson says the door is still open to a smaller hike in July given the minutes show policymakers « appear utterly oblivious … to the rollover in housing demand, which has been evident in the mortgage applications data since the turn of the year. » That will change in the June minutes, he added.

But Nomura strategist Charlie McElligott says those hoping for a Fed pause will likely be disappointed, noting Fed chief Powell’s willingness to endure « some pain » in getting price stability.

« I think that if anything, the Fed is seeing the results of their (financial conditions index) tightening campaign through these broad measures ‘slowing’ and could actually become incrementally ’emboldened’ to keep PUSHING on their hiking path until they see the ‘whites of the eyes’ of sustainably lower inflation as opposed to the notion of ‘pausing and hoping’ for the inflation data to move lower – a view that is increasing held by some in the market, » he said. (7 comments)

Snap warning

A grim forecast from Snapchat owner Snap (SNAP) gave investors another excuse to shed tech shares. The company warned of a macro environment that « deteriorated further and faster than we anticipated, » saying it was unlikely to meet its (already conservative) revenue and profit guidance for Q2.

Commentary: « $SNAP down 52% YTD before this announcement, » tweeted Stephanie Link, Chief Investment Strategist at Hightower Advisors. « Now another 25%? Why Price/Sales valuations are impossible metrics. »

Remember, Snap only reported earnings a month ago, meaning that the economic landscape appears to have changed drastically over the last several weeks. The firm will also slow hiring and postpone some planned staff additions until next year, according to an internal memo, while evaluating the remainder of its 2022 budget to look for cost savings. The latest outlook additionally pummeled digital advertising stocks, including shares of Meta Platforms (FB), Pinterest (PINS) and The Trade Desk (TTD).

Next stop: « These are pretty binary markets at the moment, » explained Deutsche Bank’s Jim Reid. « If the US doesn’t fall into recession over the next 3-6 months then it’s easy to see markets rallying over this period. However if it does, the correction will likely have further to run and go beyond the average recession sell-off (that we were close to at the lows last week) given the rich starting valuations. » (6 comments)