- The US economy softened at the margins, but many indicators remain fairly strong
- Companies finished reporting Q1 2022 earnings. A few indicators suggest that the consumer is slowing down, including both higher reported inventories at retailers and a weak retail sales report
- Inflation, as measured by the Consumer Price Index (CPI) increased to 8.6%, a 40-year high
- The Fed “surprised” the market by hiking rates 75bps rather than 50bps, which both contributed to and reflected higher volatility in fixed income markets
- Equity markets declined, with the S&P500 entering a bear market on June 13
What We Are Watching for in July:
- Corporate earnings – the big banks kick it off with both JPMorgan Chase and Morgan Stanley reporting before the open on July 14. We will be watching for credit quality, NIM (net interest margin) sensitivity, and any additional return of capital announcements, given the positive results from the recent stress tests
- We believe earnings estimates for most sectors are too high for the second half of 2022. We will be watching to see whether companies lower guidance and analysts reduce estimates to reflect slower GDP growth
- We are watching various economic releases, including Fed minutes, the June jobs report, the next CPI print, and the July Fed meeting. We are particularly interested to see if the Fed minutes provide color on how much unemployment the Fed will accept before crying uncle and pausing monetary tightening
Top-down versus bottom-up: We believe analyst earnings estimates for most sectors are too high for the second half of 2022, given economists’ significant downward GDP revisions.
In June, economic data points weakened at the margin, even as the fundamental underpinnings look to be fairly healthy. Unemployment remains a bright spot, remaining at a multi-decade low level of 3.6%. US households and corporate balance sheets remain strong. Households still have nearly $2.5 trillion in excess savings when compared to their pre-pandemic trend, while US corporate defaults year-to-date are lower than any year since 2014.
Yet, sky-high inflation – and more importantly, high consumer inflation expectations, as measured by the University of Michigan Consumer Confidence Survey – led the Federal Reserve (Fed) to increase rates by 75 basis points at its June meeting. The combination of actual rate increases and hawkish commentary has caused financial conditions to tighten considerably. To cite one indicator, the Goldman Sachs Financial Conditions Index continued to increase in June, rising to levels last seen in the depths of the pandemic, in May of 2020.
Thus, the Fed appears to be successfully sowing the seeds of economic slowdown. This will crimp demand, which should, in theory, permit inflation to decline toward more acceptable levels. Based on a number of indicators, demand is already softening. For example, May retail sales were actually negative, and the June Purchasing Managers’ Index (PMI) declined.
Economists (“top-down” market-watchers) are increasingly reflecting this in GDP estimates, which have been declining for the past 6-9 months, but equity analysts (“bottoms-up” market-watchers) are not cutting earnings at the same pace. Estimate revisions for the second half of the year have remained fairly flat, even after the April earnings reports, during which 44% of companies decreased earnings guidance, while only 15% increased them.
The reason earnings estimates haven’t declined even in a slower projected GDP environment is that analysts expect operating margins to continue to expand in 2022, 2023, and 2024, even with rising input costs, rising wages, and continued supply chain disruptions.
We believe that this will result in earnings estimate declines in the second half of 2022 and into 2023. Our analysis suggests that the sectors most at risk of declining earnings estimates include Consumer Discretionary and Industrials, which both reflect assumptions of double-digit earnings growth in 2022 and 2023. Consumer Discretionary stocks may already reflect this; they’ve corrected notably year-to-date, with the S&P500 Consumer Discretionary index down 32%. The Industrials stocks may be more at risk, as the S&P500 Industrials index has outperformed the S&P500 by 200 basis points so far, down 17%.
Looked at a different way, during recessions, earnings estimates typically decline by 14% from peak to trough, and the recent decline in bond yields suggests that the bond market is beginning to price in at least a slowdown (if not a full recession) later in 2022 or 2023. So far in 2022, although the equity market has declined by 19%, this decline has been entirely due to multiple contraction; we have yet to see earnings estimates decline. Of course, markets are known to move ahead of fundamentals, so it may be that the decline we’ve seen already predicts the negative estimate revisions to come. Alternatively, the recent pullback may have been driven by Fed tightening rather than anticipation of earnings declines, in which case further deterioration could cause more equity market weakness. Until we see broader estimate reduction or clarity that the US will avoid a recession, we remain conservatively positioned.