Wealth Insights | Weekly Market Analysis | Economy | Equities | Fixed Income
Weekly Market Analysis: Corporate Profits Still Matter
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Analyst revisions: not low enough
CIO doesn’t believe a full-blown US recession is underway, though the trend in US corporate earnings is downwards. While most firms have beaten the “low bar” of analyst estimates for the final quarter of 2022, this obfuscates the negative trend forming. The 69% beat rate for the roughly 90% of S&P 500 firms that have reported earnings was the lowest in 12 years, apart from 1H 2020. These weak results from 4Q2022 have sent analyst revisions for 2023 lower. But not enough, in CIO’s view.
Share prices haven't caught up
Share prices lead earnings per share. Last year’s almost 20% decline in share prices – coupled with surging interest rates – was indicative of where corporate profits would trend in 2023. Markets are more likely than not to price earnings declines, not rosy estimates. In CIO’s view, it may take some months before share prices reflect current economic conditions.
Data justifying higher short-term rates
The Fed is using positive economic data and “persistent” month-over-month inflation to justify ever higher short-term rates. Emphasizing lagging economic indicators that are calculated looking back 12 months ignores what’s happening now. Lagging residential rents – comparing today’s prices to those a year ago - appear to be steady or rising when rents have begun a meaningful downhill trend.
Summary
Negative business cycle risks for markets remain underpriced even as analysts’ estimates project a new record high for US corporate profits by the fourth quarter of 2023. Even after recent analyst downward earnings revisions for 2023, CIO’s own forecast for S&P 500 earnings per share is about 10% below analysts’ full-year view. Some investors see either a swift return to or continuation of strong economic growth. Others believe inflation could remain intransigent despite a Fed willing to continue on a rapid monetary tightening course to stop it. These views are inherently inconsistent with one another. Such is the state of this market, trying to balance contradictory signals. In CIO’s view, it may take some months before share prices fully reflect the lagged impact of past Fed tightening steps to discount the further weakening in business activity that CIO expects.
Portfolio considerations
CIO still believes the worst of the bear market losses were felt in 2022. But the current unsettled market conditions suggest that CIO’s defensively positioned portfolios may hold the best value.
Source: Data are for S&P 500 operating EPS as reported by Factset. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results will vary.
Analyst revisions: not low enough
CIO fears that negative business cycle risks for markets remained underpriced even as analysts’ estimates project a new record high for US corporate profits by the fourth quarter of 2023. Earnings per share (EPS), a metric used for estimating corporate value, fell at a 14% annualized rate in the second half 2022 (Figure 2). EPS in the fourth quarter of 2022 were 4% below CIO’s quarterly estimates. For the first half of 2023, CIO expects EPS to continue falling at roughly the same pace, leaving full-year 2023 EPS 10% below last year’s. Even after recent analyst downward earnings revisions for 2023, CIO’s forecast for S&P 500 EPS is about 10% below their full-year view. So, who’s likely to be more accurate? Analysts project the spring quarter EPS to rise 31% (on an annualized basis). This is the period when CIO thinks US economic activity measures will be declining most rapidly, as firms address high inventories by slashing production.
Share prices haven’t caught up
Last year’s almost 20% decline in share prices – coupled with surging interest rates – was indicative of where corporate profits would trend in 2023. Markets are more likely than not to price earnings declines, not rosy estimates. In CIO’s view, it may take some months before share prices reflect current economic conditions, reflecting further weakening in business activity. Later in 2023, CIO expects markets to begin to focus on the recovery of 2024, when CIO expect a 5% EPS gain, strengthening into 2025 and beyond. But not before a reconciliation between real earnings and valuations.
Data justifying higher short-term rates
For many economists, the idea that the whole US economy has had a sudden, sharp acceleration at the start of 2023 seems implausible. Did US employers decide to double their hiring pace in January while simultaneously announcing the largest layoffs since the COVID shutdowns? And did US retailers, in fact, experience a sudden spending boom in January after reporting poor holiday sales ? The Fed is using the positive economic data and “persistent” month-over-month inflation to justify ever higher short-term rates. Emphasizing lagging economic indicators that are calculated looking back 12 months ignores what’s happening now. Lagging residential rents – comparing today’s prices to those a year ago - appear to be steady or rising when rents have begun a meaningful downhill trend. Here’s another example: Current demand for US labor reflects current production requirements. Residential homes started 12-18 months ago are being finished for delivery now. However, the surge in interest rates has caused a historically sizeable drop in home sales, with new housing permits and starts following sales lower. Construction employment across the industry could adjust to the much slower future production pace once housing units under construction are finished. While this isn’t the immediate condition for housing employment, it is the near future. This dynamic occurs across many industries with high inventories. It might impact related services employment, too, as marketing, advertising, customer service and finance activities associated with industry are curtailed. All of this can occur even as certain sectors, like travel and tourism, still exhibit growth due to pent-up, Covid-related demand.
Portfolio considerations
Some investors see either a swift return to or continuation of strong economic growth. Others believe inflation could remain intransigent despite rapid US monetary tightening. These views are inherently inconsistent with one another. Such is the state of this market, trying to balance contradictory views and signals. CIO still believe the worst of the bear market losses were felt in 2022. But the current unsettled market conditions suggest that CIO’s defensively positioned portfolios may hold the best value. This is why CIO is emphasizing greater bond exposure as real US yields (+1.5% to 2.0% in TIPS markets) are historically attractive against our current backdrop. Investment grade corporate bond yields are high (5.8% for nominal long-term issues, greater for hybrid securities). CIO is also maintaining defensive equity exposures, with the most consistent dividend growers in the US market remaining the our largest off-index position. Aside from “high quality” exposure, other areas CIO likes are beaten-down biotech and life sciences, energy (both old and new), defensive industrials, preferred stocks, and local Chinese equities. More generally, CIO’s largest positions remain in reliable sources of return for portfolios: investment grade company dividends and coupon payments for the highest quality borrowers. By many measures, these yields are now the most generous in 15 years or longer.
