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.
Copper is nowhere near the highs of 2021.
That AAPL and MSFT are great companies is undeniable, but if there is global belt tightening, they are not immune. They have to sell their products or services.
I wonder about money glut…all this pandemic cash that circulates until it finds a place …eg Joe gets a stimulus check and goes and spends it which helps somebody’s business of which some may get into a 401k which gets into an ETF or stock, (it doesn’t matter), and just stays there. Does this put some kind of floor on the market or buffer the price moves?
A lot of stuff is not priced to market, what happens if that gets forced? Money goes to heaven and needs to move from somewhere to replace it.
The pop on the CPI print feels wrong, it was also accompanied by a jump in stocks like Carvana and Nikola which unless we get a GME like squeeze are going nowhere….I confess to not having checked the short interest on them. This makes me think that retail jumped onto the “pause” train. The irony of course is that any real pivot is usually accompanied by a crashing market.
Anyways this market stinks. Add to that the yield curve inversion and one has to wonder when the shoe will drop.
Revenue forecast for Q2 of negative .4% is at odds with Q2 real GDP of 2.3%. Nominal GDP was probably closer to 6%. I think the q2 reports may surprise to the upside for revenue and eps.
Key is the forecast and guidance. No one is likely to paint a rosy picture in light of slowing economic growth. Rate of inflation is down but prices are elevated stretching the consumer.
With high valuations, I think market treads water till Fed stops hiking.
Atlanta Fed’s GDP now is showing 2.3% GDP. Still high IMHO.
Using China as a barometer for world economy used to be a very good estimate. But it is not reliable anymore, just like many other indicators. The world keeps changing, and changing faster. Many factories have moved to SE Asia, India, and Mexico. China was the biggest exporter to US by a wide margin only a few years ago. The number was way bigger than sum of Canada and Mexico. Now Mexico is #1 and Canada is #2. And Mexico’s number alone is bigger than that of China (at #3). The trend continues downward. There is no catalyst to reverse it. It will only get worse and faster. Many factory and orders data from SE Asia and India and Mexico show tremendous growth. These orders are not just for US. It is for EU too. China is going back to be an isolated Kingdom like it has been for many centuries. Recent Chinese biz delegates to US and Europe to look for deals yields a big ZERO. It has never happened in the last four decades.
But there are still many people in US looking for profit in China. Perhaps due to a recency bias. It used to easy if you have connections. Even this route is now blocked. In essence China’s new Dear Leader has led the country into a maze it can’t get out of. Many countries are de-risking from China. This is not say China will disappear. Far from it. With its big population there is a big internal market for a decent-sized economy. Just that it will not grow and its influence will dwindle steadily as time goes by. Looking for China to be the engine for global growth in the future is not a good use of your time. Just a small example to show where the money is flowing. Taylor Swift just increased her number of concerts from three to six in Singapore with ticket prices into thousands of USD. Other global acts are regularly performing there too. On the other end Disney parks in HK and Shanghai has never made money since opening. The implication is that perhaps money is not as abundant as we are led to believe in China. For sure for CCP members it is a complete story.
OECD data on the world economy is actually showing growth, and in early stages. Stock markets around the world are rising to signal the trend change from trough.
Great point.