On To Earnings

1414 words – a 4 minute read.

Given that it is American football season it seems appropriate to invoke NE Patriots head coach Bill Belichick’s famous adage “on to Cincinnati” which he gave back in 2014 after a blow out loss to the Kansas City Chiefs… his focus forward comment led to a W vs Cincinnati and a 4th Super Bowl victory in the famous goal line interception game vs Seattle (yes, I grew up in Mass and am a Pats fan). So, while inflation is all the rage its on to earnings season.

But first, the relentless rise in US inflation prints continued yesterday with another new high in core inflation at 6.6% y/y, frustrating those like us at TPW Advisory who have been anticipating a more visible and sustained roll over in inflationary pressures given all the places where prices are clearly slowing. We appreciated the comment made by Ian Shepherdson of Pantheon Macro, whose work we like a lot: "Evidence of falling inflation is everywhere except in the inflation data."

As we have been discussing, first in our Monthly & then in last week’s Musings  we believe continued extrapolation of these trends is increasingly dangerous for investors. Yesterday’s US equity market action is a perfect encapsulation of what we wrote about in “Two Sided Markets” last week. A 2% drop to start the day followed by a sharp rally to leave the SPY up 2% is only the 5th such reversal day in the past 30 years according to Bespoke Investment Group.

Markets are wrestling with the expected decline in inflation as a result of Central Bank rate tightening together with the fear of weak earnings given the typical impact of the blunt monetary tool on economic activity. So far, neither event has occurred – inflation remains well above comfort levels on a y/y basis especially while earnings continue to be supported by the high nominal growth environment we have been writing and talking about all year.

This standoff has led some smart economic commentators to begin to question the utility of killing off the best DM jobs market in a generation. Martin Sandbu of the FT wrote a solid piece on this issue recently while The Economist wrote a similar piece about what comes next, noting: “a brave new world of somewhat higher government spending and somewhat higher inflation would have advantages”. 

Here is the $ quote from Sandbu: “Let’s be frank: central bankers are about to address a cost of living shock by willingly inflicting a hit to growth and jobs that could go as far as causing a global recession. They claim this is preferable to the alternative. But they must spell out better why the alternative is so much worse. Their “credibility” is itself no more valuable than what it allows you to do.

If the aim is to avoid inflation settling at a moderately higher level, we need to be told why that is worse than giving up on a stellar jobs market. If it is to prevent a self-reinforcing dynamic in which wages and prices keep driving each other up, then truly independent central bankers should hold fire until they see the whites of the eyes of such a wage-price spiral.

Instead they increasingly leave an impression of buckling under political pressure that comes with high inflation reports today, which they cannot influence. Instead they should be focusing exclusively on the (much more benign) medium-term inflation outlook, which they can”.

We remain of the view that US inflation is ebbing (compare Q3 3M CPI inflation annualized at roughly 2% vs Q1 or Q2 at 10% + for example), that this will become increasingly evident in the data as times passes and that the Fed will be looking for an off ramp from the 75 bp hikes now penciled in as a surety for November and perhaps December as well.

This is especially true given that cross asset markets have already priced in a Fed/ECB which will continue to raise rates (terminal rates of between 4.5-5% in the US and 2 – 2.5%n in the EU) & that financial stability risks tend to elevate with real rates & financial conditions at current levels. Much depends on US service price pressures as September’s core goods prices were flat m/m – the best result since March. When that happens, we expect the USD to follow suit and roll over, opening up a range of cross asset allocation opportunities.

We remain of the view that global economic and monetary policy is desynchronized with the US and EU tightening and slowing while Asia either stands pat (BOJ) or eases in the case of China’s PBOC as September core CPI grew at the slowest pace since March 2021. Asian growth is picking up across the region, from Japan to China and on to SE Asia. We note a decent chance of further policy easing in China post this weekend’s PPC meeting as well.

We expect the high nominal growth world to continue and share The Economist’s view as to a brighter future ahead with public/private spending on a cap ex boom to confront the challenges posed by: Covid, Climate & Conflict. A productivity surge is likewise likely to be part of the story over the coming years – perhaps as WFH ebbs. Our analogue remains the US economy over the  2nd half of the 1990s. In this scenario earnings remain supportive of equity prices and the much feared sharper equity price decline due to a sharp falloff in said earnings will fail to materialize.

Speaking of earnings, FactSet notes “the S&P 500 is expected to report (year over-year) earnings growth of 2.4% for the third quarter, which would be the lowest earnings growth reported by the index since Q3 2020. Given that most S&P 500 companies report actual earnings above estimates, what is the likelihood the index will report actual growth in earnings of 2.4% for the quarter?

Based on the average improvement in earnings growth during the past few earnings seasons due to companies reporting positive surprises, it is likely the index will report earnings growth between 6% and 7% for Q3. In fact, the actual earnings growth rate has exceeded the estimated earnings growth rate at the end of the quarter in 39 of the past 40 quarters for the S&P 500. The only exception was Q1 2020.

More recently, the improvement in the earnings growth rate has been below the 5-year average and below the 10-year average. Over the past two quarters (Q1 2022 and Q2 2022), actual earnings reported by S&P 500 companies exceeded estimated earnings by only 4.0% on average. During this same period, 76% of companies in the S&P 500 reported actual EPS above the mean EPS estimate on average. If this average increase is applied to the estimated earnings growth rate at the end of Q3 (September 30) of 2.8%, the actual earnings growth rate for the quarter would be 6.3% (2.8% + 3.5% = 6.3%)”.

Q3 EPS estimates are pretty decent for the rest of the world as well with the EU expected to have similar EPS growth rates to the US while Asian EPS growth should be supported by its better growth profile. Much attention will be paid to forward guidance – especially into 2023 with its SPY $240 consensus; a number of firms (BofA, MS) are expecting a much lower 2023 EPS of $200.

US seasonality has turned positive, sentiment and positioning remain way offside, the pendulum swing from extrapolation to two sided markets to a new trend seems to be moving apace. Several technical analysts we read are noting signs of basing and indecision in stocks, suggestive of a transition or prelude to a turn. Non US equity markets remain extremely cheap, priced in depressed fx, completely under owned, etc. etc.

Bear market media: the FT headline on the IMF’s updated economic forecasts: “The Worst is Yet to Come” vs the reality of its .2% tweak from its 2023 2.9% global growth forecast to 2.7% says it all. Bear market grind: as Carson Group noted recently SPY has been green on only 43% of trading days ytd, the lowest % since 1974… that explains a lot.

Enjoy the weekend and GO DUKE! Big game Saturday night vs the locals from down tobacco road – hit me up if you want to hear how I got tossed from my last game my senior year at Keenan…GTHC, GTH!!!!