Here’s what I am watching.
The margins question
In a recession, margins come under pressure. How will margin estimates evolve during Q2 earnings season? FactSet reported that analysts expect year-over-year EPS growth to fall -7.1% during Q2 and revenue to fall only -0.4%, indicating margin compression. Q2 is already history. The key question is margin estimates for Q3 and Q4. In particular, the profitability in small-cap stocks appears ominous. About one-third of the Russell 2000 is unprofitable and the trend is rising.
The good news is that earnings expectations are recovering, albeit in a choppy way. These are early clues of margin expansion.
A bifurcated market
The U.S. equity market has become highly bifurcated. The advance has been led by a handful of megacap growth stocks. Even as the S&P 500 staged an upside breakout to new recovery highs, the equal-weighted index, which is indicative of the average stock, has gone sideways and only testing a resistance zone. Keep an eye on the earnings results for megacap techs, as they could set the tone for the market. Big Tech companies began to announce layoffs in late 2022. Will there be more downsizing announcements, or will the reduction in staff sufficient to move the needle to boost operating margins?
What about the American consumer and the rest of the market? The early indications are mixed. PepisCo results are a case in point. Organic revenue was up 14% YTD, while volumes were flat to down. The company has pursued a price over volume strategy, which is indicative of strong branding and unwelcome signs of “greedflation”.
High frequency indicators of retail sales are weakening. The weekly reported Redbook Index, which measures same-store sales of large general merchandise retailers, saw its YoY growth go negative last week. While this is just one data point, it is nevertheless an indication of softness in consumer spending.
On the other hand, travel stocks have been rising strongly, which is an indication of strong consumer spending. Delta Airlines, which may be a bellwether for the group, reported last week. It beat both sales and earnings expectations and guided higher.
Lastly, don’t forget China as key indicator of the global economy. China reported a stronger-than-expected trade surplus, but internals were weak. Chinese exports tanked, indicating global weakness, and imports softened, though they fell less than exports.
What about the recession?
What about the recession, which is becoming the most anticipated recession in history. While opinion appears to be evenly divided between the recession and soft landing camps, an economic downturn has the potential to sideswipe expectations of earnings and margin growth.
The jobs market may be about to crack. New Deal democrat has been tracking the evolution of initial jobless claims. He found that year-over-year increases of the 4-week average of initial jobless claims of over 12.5% tended to be recession signals. We’ve seen five consecutive readings of growth over that benchmark. While NDD isn’t ready to make a recession call just yet (see Initial Claims Move Closer to Red Flag Recessionary Warning), these readings don’t look like data blips and are starting to look ominous.
The soft June CPI report sparked a rally in stock and bond markets. Both headline and core CPI came in below Street expectations, but much depends on the Fed’s reaction function. A quarter-point increase in the Fed Funds rate is baked in at the July FOMC meeting, but much depends on what the Fed is watching and placing the greater weight on its decision-making process. Supercore CPI, which is a metric often cited by Chairman Powell, showed signs of collapse.
On the other hand, average hourly earnings is running at an annualized 4.7% rate and it’s showing few signs of deceleration.
The inflation fight narrative is changing to the last-mile problem. It may be easy to get inflation down to 4%, but it will be far more difficult to push it down from 4% to the Fed’s 2% target. This raises the risk of a Fed policy overtightening mistake and craters the economy into recession.