August 9, 2022—A pivotal earnings season is nearly in the books, and the results have given fodder for the bulls. The S&P 500 index is up 9% since earnings season kicked off on July 16. Importantly, this is also a period that has coincided with declining energy prices, lower interest rates, and a Federal Reserve (Fed) meeting for which market participants exhausted themselves reading between the lines. Yet, for bulls and bears alike (and everyone in between), the mixed results from earnings season may be a bit unsatisfying, as we find ourselves right back where we started—looking for confirmation of whether the glass is half full or half empty. It is for this reason that we are keeping our clients fully allocated to equities but not chasing the recent rally.
At the start of the second quarter, expectations were for the S&P 500 to grow earnings by 4.0% year-over-year (y/y). With 87% of companies having reported, earnings are beating expectations and pointing to earnings growth in the second quarter of 6.7%, an impressive upside surprise considering the disappointing nature of some of the second-quarter economic data. Revenues have grown 13.6%, also well ahead of expectations.
Without diminishing the strength of these overall results, our analysis of company-specific results, earnings calls, and guidance bring three important themes to the surface.
- Revenues are up, but output is weak. Many consumer-facing companies have delivered solid revenue growth, but price hikes are masking weak or even declining output. This trend is evident across the consumer staples space, including cleaning & household goods companies like Clorox and Procter & Gamble, as well as food & beverage companies from Kraft Heinz and Blue Apron. Weak output may be a result of consumers trading down to generic brands or just trying to stretch what they have. While guidance has indicated some companies like Chipotle and Starbucks expect they still have pricing power, our expectation is that companies will take weakening demand as a sign that price increases need to moderate.
- The consumers are still “showing up”—at least for their vacation. Early in the reporting season several large banks confirmed that consumers remain in good health, undoubtedly aided by a tight labor market and some pent-up savings at the top of the income distribution. Consumers are utilizing debt, as evidenced by a 13.8% y/y increase in revolving credit. However, overall levels of credit remain below pre-pandemic levels after adjusting for inflation. Robust results for airlines, hotels, entertainment, and other tourist-related industries confirm that the post-COVID, vacation-starved consumers are making up for lost time. This is great news for the current health of the services economy, but if demand remains too robust, it could result in sticky inflation going forward.
- Energy is masking weakness. In the post-Global-Financial-Crisis recovery we experienced several mid-cycle slowdowns due to a weak energy or manufacturing sector. We became accustomed to peeling energy out of earnings and credit data to reveal stronger results for the rest of the market. Now we find ourselves in the opposite position of separating out incredibly strong energy earnings results to reveal weakness in the rest of the S&P 500. The energy sector in the second quarter posted an astonishing 299% y/y earnings growth. While energy is less than 4% of the index, when we exclude energy, the rest of the S&P 500 has seen earnings contract by 3.7%.
The next week will provide a look into the retail sector, where Target and Walmart have already warned of waning demand and rising inventories. As we look ahead, we are using earnings expectations as one gauge of what is priced in the market. Bloomberg’s analyst consensus expectation for 2023 earnings on the S&P 500 is $245, an 8% growth from 2022 earnings estimates. Even without assuming a recession, this could prove too optimistic for a slowing economy at peak profit margins. Expectations for 2023 earnings in consumer discretionary and communication services have been revised down 8—11% since the beginning of the year, but other sectors remain relatively untouched. If earnings estimates are to be believed, the 17.5x forward earnings multiple on the S&P 500 represents a fair valuation for U.S. equities. But that multiple is now back above the 24-year average, and if earnings estimates require further downward revision, stocks will not look as cheap. A tight labor market, input costs, and a strong dollar continue to weigh on margins, which are declining from record highs (Figure 1).
Figure 1: Profit margins vulnerable to rising input costs, slowing demand, and stronger dollar
S&P 500 next-12-month profit margin
Data as of August 5, 2022. Source: Bloomberg. Shows net profit margin, after taxes and other income.
The outlook for the economy and markets hinges on the trajectory of inflation, though the COVID economy and recovery have made that forecast very challenging. We expect headline consumer price index (CPI) to slow to 2.6% y/y one year from now, but we recognize risks to the upside and downside of that forecast. We think it is important for investors to focus less on predicting the exact path of inflation and Fed policy and more on which of the range of possible outcomes the market is discounting. The last month has proven—if nothing else—the dangers of sitting out the market.
We retain a benchmark-weight to equities, yet we do not feel investors are being adequately compensated for taking on additional risk in the form of an overweight to equities. A recession is not our base case over the next 12 months, but a deeply inverted yield curve would beg to differ, and we place a 35—40% probability of a recession in 2023. Within equities, we have rotated modestly away from value toward growth, where we see relatively more attractive valuations, improved momentum, and a factor that could outperform if economic growth remains below trend. Equity volatility has been contained, but bond market volatility remains very elevated, and we are choosing to place our defensive chips into the cash basket, rather than in bonds. We hold an overweight to cash and modest underweight to investment-grade fixed income.
 Source: Factset Earnings Insight, as of August 5, 2022.
 Source: Factset Earnings Insight, as of August 5, 2022.
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