US Strategy Weekly: Perception versus Reality

Earnings, and earnings growth, are the bedrock of the equity market. And they can be especially important in an environment like the present where recession fears are plentiful. Therefore, we continue to focus on second quarter earnings results, yet we are having trouble reconciling perception versus reality in this department.

According to Reuters, “US companies are reporting mostly upbeat news this earnings season, surprising investors who had been bracing for a gloomier outlook on both businesses and the economy. More than halfway into the second-quarter reporting period, S&P 500 company earnings are estimated to have increased 8.1% over the year-ago quarter, compared with a 5.6% estimate at the start of July.” However, data from IBES Refinitiv shows that their S&P 500 earnings estimates for 2022 and 2023 fell $1.25 and $2.02, respectively last week, after rising only a penny for 2022 and falling $0.78 for 2023 a week earlier. Similarly, forecasts from S&P Dow Jones indicate earnings estimates fell $2.42 and $2.91, respectively, last week and fell $2.48 and $0.36, respectively, a week earlier. These sharp drops in estimates during peak earnings season hardly support the statement of “better than expected” earnings in the second quarter.

However, Howard Silverblatt, Senior Index Analyst at S&P Dow Jones Indices, may have said it best in the U.S. Equities Market Attributes July 2022 (August 2, 2022) report. He noted that: “while earnings for Q2 2022 were expected to increase 13% over Q1, the whisper numbers were much lower, as was the concern over the second-half guidance. However, actual earnings (72.1% reported) did not make the expected 13% gain and now indicate a 7% gain, which is a headline disappointment for some, but not if you were one of those money managers (or traders) who traded into the whisper numbers (and sold). For them, it was an unexpected beat and a time to reallocate…”

In other words, hedge funds were positioned for sharp earnings declines and were relieved at the actual numbers, even though they did not beat the consensus estimates. This is quite different in our opinion from an actual increase in earnings growth — which did not materialize. In fact, the nominal dollar earnings range for 2022 fell to $218 (S&P Dow Jones) and $227 (IBES). S&P Dow Jones and IBES earnings growth rates for this year sank to 4.8% and 9.1%, respectively. And while second quarter earnings season is less than 75% complete, we find that our DRG 2022 estimate of $220, a 5.7% YOY increase from $208.19 in 2021, is at risk and is currently under review. See pages 11 and 18.

Moreover, what the Reuters article failed to mention is that even though the IBES report shows an overall blended earnings growth estimate of 8.1% for the second quarter, if the energy sector is excluded the earnings growth rate falls to negative 2.5%. This was an important omission. And we would advise monitoring the much-discussed Senate’s Inflation Reduction Act since it would currently reinstate the Superfund tax on crude oil and imported petroleum at 16.4 cents per gallon (indexed to inflation) and increase other taxes and fees on the fossil fuel sector. Obviously, this would hurt S&P earnings since so much of the earnings growth in the last 18 months has come from the energy sector. More broadly, the bill would instate a minimum 15% tax rate on all corporations. This again, would negatively impact earnings. In sum, we are not finding comfort in second quarter earnings results or current fiscal policy.

Monitoring Economic Data

With first quarter GDP growth already inked at negative 1.6% and second quarter falling 0.9%, the US economy is technically in a recession. Many will be debating this issue in coming months, but the calculation for GDP makes it rather difficult to record a negative number after a negative quarter. In short, 2Q22 GDP implies economic activity continued to slide in the April through June period. The GDP price deflator also jumped to 7.5% YOY in the quarter, the highest pace seen in this indicator since the December 1981 report of 8.4%. Note that the December 1981 reading took place in between the 1980 and 1981-1982 recessions. These two recessions were also triggered by Fed rate hikes as monetary policy struggled with an inflationary cycle. See page 3.

The ISM manufacturing index fell to 52.8 in July, the third consecutive monthly decline, the fourth decline in the past six months, and remaining below a six-month average of 55.5. New orders declined from 49.2 in June to 48 which is the second consecutive month that new orders were below the neutral threshold of 50. All in all, this is a display of declining momentum in manufacturing. See page 4.

Homebuilder confidence fell from 67 in June to 55 in July and is at its lowest level since early 2020. The June pending home sales index fell from 99.6 in May to 91.0 in June, which was the lowest reading since the March/April 2020 recession readings and the third lowest since data began in 2018. Still, the homeownership rate edged up to 65.8% from the first quarter reading of 65.4%, with the strongest gains seen in the South and West sections of the country. The housing sector began to slow well before the Fed increased rates this year and we expect it will continue its slump throughout the second half as interest rates continue to rise. See page 5.

The personal savings rate fell from 5.5% to 5.1% in June and sits at its lowest level since the 2008 recession. Real personal disposable income, which was $15.10 trillion in June, remains below its pre-pandemic February 2020 level of $15.16 trillion and is one sign of potential weakness in consumption. And despite recent monthly job reports, this does not tell the whole story. Total employment remains more than half a million jobs below its February 2020 peak level. See page 6. Inflation has also changed household spending patterns. See page 7. In the 18 months ending in June, household spending for gasoline and other energy goods increased 106%, transportation services increased nearly 50% and food services and accommodations rose nearly 45%. These increases have reduced household consumption of things other than energy and food. See page 7.

With the yield curve nearly inverted, the debate about whether or not more rate hikes will be implemented this year will intensify. Nevertheless, June’s personal consumption expenditures index, the favorite inflation measure of the FOMC, indicated price trends were accelerating and the index rose 6.7% YOY, the highest rate since January 1982. Excluding food and energy, the PCE index is rising at a 5% YOY pace, the highest since records began in 1987. This report implies more rate hikes are required to tame inflation. See page 9.

Multiple Signs of Recession

The WTI crude oil future is at $94.42 and below its 200-day moving average now at $94.70. The longer the future trades below the 200-day MA, the more likely oil prices will fall further to the $80-$85 range. This decline in oil would bring relief to future inflation, but it is not a result of Fed rate hikes. More exactly, energy is falling due to fears of weakness in China’s economy, as a result of shutdowns, weakness in manufacturing and troubles in the real estate sector. Meanwhile, the 10-year Treasury note yield at 2.74%, having recently reached an intra-day low of 2.52%, has become very volatile and is signaling economic weakness. With the fed funds future at 2.5%, a falling 10-year Treasury yield increases the likelihood that the entire Treasury yield curve will invert resulting in a classic sign of a recession.

And lastly, Technicals The recent equity rebound carried all the indices up to their 100-day moving averages which are now at roughly DJIA: 32,719; SPX: 4,119; NAZ: 12,335; and RUT 1,873. However, only the Nasdaq Composite is currently trading above its moving average. These moving averages are only first-level resistance points, yet they could prove to be pivotal for the intermediate term. At present, the market appears to be wobbling at this resistance level. In sum, we continue to maintain a relatively cautious stance focusing on stocks where earnings are most predictable, even in a recession. In general, this equates to energy, staples, utilities, and defense stocks.

Gail Dudack

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