Confidence Game

By Matthew Gutierrez, Shawn O'Malley , and Weronika Pycek · August 08, 2023

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In 2020, Minneapolis Fed President Neel Kashkari said, “There’s an infinite amount of cash at the Federal Reserve” for stimulating the economy. But there are very real, practical limitations to the Fed’s effectiveness in taming inflation.

This includes the collective trust in what the Fed says, which is why it has responded so dramatically to the pandemic-era inflation spike.

???Without credibility, its job gets much harder. Yet, confidence in the Fed is at multi-decade lows — not good. See our Chart of the Day for more.

—?Shawn & Matthew

Here’s the rundown:

Today, we'll discuss the?three biggest stories in markets:

• Moody’s downgrades U.S. banks
• Why your electric bill may come down soon
• Eli Lilly flies high

All this, and more, in just?5 minutes to read.

POP QUIZ

Which state in the U.S. has the highest electricity prices? (Read to the end to find out!)

CHART OF THE DAY

IN THE NEWS

?? ♂???Moody’s Downgrades U.S. Banks (Reuters )

The credit rating agencies are back in the news. No, Moody’s isn’t making headlines for following?Fitch’s footsteps ?last week by downgrading the U.S. government — it’s the last of the big three who still gives the U.S.A. a perfect credit rating. Instead, the firm turned its attention to U.S. banks.

• Moody’s credit rating downgrades?hit 10 small and mid-sized banks?while placing banking giants like the Bank of New York Mellon (America’s oldest bank), Truist Financial, State Street, and U.S. Bancorp on a watch list.

Why??“Funding risks and lower profitability.”

What that means in English:?For decades, banks have enjoyed stable deposit bases, which they’ve used to fund their lending activities. Past generations had very loyal, long-term relationships with their banks, and banks used that to their advantage.

• In the digital era, people are?much less loyal to their banks, pulling funds immediately using their bank’s app. Switching banks to shop for more competitive interest rates is seamless. And when worries about the banking system surge, bank runs are accelerated.
• As Silicon Valley Bank’s?blowup ?earlier this year showcased, a bank run can now occur in hours, not days or weeks. Hence, why Moody’s is turning pessimistic on a number of banks for “funding risks” — banks face much more volatile customer deposits.

What about profitability??Well, as a regulatory consequence of this year’s bank runs, it’s expected that banks will be required to hold more capital on their balance sheet against loans, reining in the amount of lending they can do, which drives banks’ profits.

• Per Moody’s, “This comes as a?mild U.S. recession?is on the horizon for early 2024…with particular risks in some banks’ commercial real estate portfolios."
• Banks are cyclical businesses, making the most money when the economy grows (they can lend more and do so at higher interest rates.)

Why it matters:

The Federal Reserve’s interest-rate campaign “continues to have a?material impact?on the U.S. banking system’s funding and its economic capital,” Moody’s noted.

• Higher rates have reduced the value of bonds and other assets owned by regional banks (bond prices and interest rates have an inverse relationship.)
• The result??Lenders are left with “sizable unrealized losses” and are vulnerable to large stock-price drops when investors panic.

Confidence game:?Moody’s downgrades strike another blow to struggling regional banks, hit by a cascade of customer withdrawals to their “too big to fail” peers, bad commercial real estate loans, particularly for office buildings, and rising interest rates which have hurt the value of their bond investment portfolios.

• While the Fed’s interest rate hikes do enable banks to capitalize on higher-interest-rate loans, fears about the banking system have spurred a more cautious approach to lending, slowing the process with which low-yielding loans are offset with more profitable, higher-interest-rate loans.

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???Fingers Crossed, Your Electric Bill May Fall Soon?(WSJ )

Most Americans have at least one thing in common:?Growing electric bills over the last three years.

Natural gas and coal jointly fuel around?60% of the U.S. power grid, and prices for both have been dropping, finally rippling through into lower utility bills.

• One Goldman Sachs economist, Spencer Hill, expects average electricity prices to decline?3-4%?from their peaks by this fall.
• While natural gas and coal costs are down around?54%?from last year, rising labor and interest costs have helped prop power rates up.

Power 101:?Your electric bill depends on many factors. Electricity prices vary with seasons, location, and weather. Still, Americans, on average, pay?25%?more for power than they did before Russia’s invasion of Ukraine, which shocked global energy markets.

Another factor??State rules governing how and when utility companies can hedge costs and pass on higher prices to customers.

• For example, in New Jersey, utility companies can enter contracts to hedge energy input costs for up to three years in advance, helping lock in more stable rates for folks, compared with Florida, where power producers tend to hedge less.

Sinking profits:?Comparatively, milder weather nationwide in the first half of this year has reduced demand for power (less need for heating in the winter & AC in the spring/summer), hitting utility companies’ profits.

• American Electric Power, Dominion Energy, Southern Co., and Xcel Energy all reported a year-over-year decline in second-quarter earnings.
• That decline in profitability illustrates why the utility sector has?lagged every other sector in the S&P 500?in 2023, dipping 9.5% while the S&P 500 has gained some 18%.

Why it matters:

Last year, utility stocks with their high dividends were a?haven?for investors as the market broadly sold off. Utility stocks declined only 1.4% in 2022, whereas the S&P 500 fell 19%.

• Things are different now:?As one investor said, “With 5.5% (yields) in a money-market fund, why bother earning 4% with Southern Company?”

In other words, given that utility companies have little business growth and appeal to investors with their cash dividend payments, that appeal is greatly reduced when money-market funds and high-yield savings accounts offer higher payout rates with less risk.

Spending boost:?Lower electric bills would also help consumers, potentially increasing the amount of money available for discretionary spending. If so, the economy would be more likely to achieve a so-called “soft landing” after hiking interest rates, where inflation can cool without spawning a recession.

• The Goldman economist, Spencer Hill, thinks this spurt in spending from lower electric bills could offset as much as?half of the impact of student-loan payments?resuming soon for millions of Americans.

MORE HEADLINES

???Americans are?pulling money ?from their 401(k)s at an alarming rate.

???Philly Fed President?suggests ?interest rate hikes are at an end.

???Banks hit $500 million+?fine ?for using messaging apps to evade regulators’ reach.

????Eli Lilly Flying High?(Barron’s )

Like utilities, healthcare stocks are usually seen as slow and steady, “recession-proof” businesses because of their essential nature. Let’s face it, we all need healthcare regardless of economic conditions.

Count?Eli Lilly?as an outlier. The stock is up nearly?45%?in 2023 and more than 400% over the past five years. Its Tuesday rally of nearly 20% has sent shares to a record high because its weight-loss drug,?Mounjaro, registered?$979.7 million?in second-quarter sales, up from just $16 million a year ago.

• Eli Lilly closed Tuesday with a market value above $500 billion for the first time.
• Covid vaccines are (mostly) out of the news this year, but anti-obesity medications have taken off, with drugs like Ozempic becoming popular for an aging, more obese U.S. population.
• Denmark’s?Novo Nordisk?makes?Ozempic, and its shares are up nearly?40%?year-to-date vs. the S&P 500’s 17% gain. Novo Nordisk also surged this week thanks to a large study showing its anti-obesity drug,?Wegovy, reduced patients’ risk of heart attacks, strokes, and cardiovascular deaths by?20%.

Ramping up:?Eli Lilly’s CFO said the company is accelerating capacity at a new facility in North Carolina that produces Mounjaro and similar drugs, adding that supply would “likely remain tight in the coming months and quarters.”

• The quarterly results could also “support access for any payers who are on the fence about covering obesity medications,” the president of Eli Lilly’s diabetes division said.
• He added that the results should “turn the conversation on the benefits of weight loss away from aesthetics and more toward the?health benefits?of people living with obesity.”

People who are overweight have a 25% increased risk of heart disease compared to those with normal weight.

Why it matters:

Eli Lilly is attempting to mitigate a growing problem: Obesity. There’s?enormous market opportunity?in the anti-obesity space.

• Data from the National Health and Nutrition Examination Survey found more than?two in five adults are obese, and about one in five children are obese. Researchers have found a “sedentary lifestyle” – lots of TV, sitting, high-fat foods, and limited exercise – driving the trend.
• For Big Pharma, billions of dollars are on the table in the race to get quality anti-obesity drugs to market.

Wegovy, a diabetes drug for weight loss,?and other similar drugs in development at Eli Lilly could have long-lasting health benefits beyond shedding unwanted pounds, a source of encouragement for investors.

• Eli Lilly’s stock has been on a tear also because of positive trial results for its Alzheimer’s drug,?donanemab, and its progress with other promising obesity drugs.

TRIVIA ANSWER

Hawaii.?According to AARP, the average American household spends around $118 per month on electricity, but in Hawaii, that figure is well over $200.

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