I doubt seriously that anyone needs to have the risks enumerated for them again, but I suppose another recap of key themes can be justified if it’s contextualized via the onset of earnings season.
I’ve warned on the potential for “gale-force” macro headwinds. I think that’s an accurate characterization (i.e., not just hyperbole for hyperbole’s sake) when it comes to, for example, a severe slowdown in China and the prospect of consumer retrenchment stateside. But most of the known hurdles seem manageable. Even a sharp deceleration in China won’t likely be a total disaster, keen as the Party is on managing expectations and outcomes.
The only issues that might properly be described as “insurmountable” are those that relate to supply chain disruptions. I don’t necessarily mean insurmountable in the sense that the world might stop spinning. Rather, I mean that goods and services might stop spinning around the world.
The pandemic laid bare what now seems obvious, hindsight being a helluva lens. The globalization of supply chains and various manifestations of just-in-time worked all manner of miracles, but interconnectedness has a price. And we’re paying it now, figuratively and literally. In all likelihood, many corporates will re-shore where and when possible. The irony is that while price increases tied to supply chain disruptions can theoretically be ameliorated by bringing more aspects of production back home, the loss of various cost savings associated with globalization will be lost in the process. One way or another, higher prices may be here to stay.
So, when it comes to supply chain disruptions, I use “insurmountable” to suggest that it may be quite a while before things return to normal, and if enough production is brought back home, we may never see “normal” again. De-globalization was already “a thing” pre-pandemic thanks to the rising tide of nationalism/populism. Whatever momentum it might have lost when Donald Trump departed the White House may have been regained thanks to the virus.
In any event, this has huge implications for corporate earnings. Goldman noted late last week that the ISM Suppliers Deliveries Index averaged 74 over the past six months. That’s the highest in nearly 50 years. Out of 26 S&P 500 companies that reported results over the past several weeks, 18 of them spoke about supply chains on their respective calls.
“The average consensus revision to Q4 2021 EPS for these firms has equaled -4% but our economists estimate that strong goods demand accounts for two-thirds of global manufacturing delays,” Goldman’s David Kostin said, adding that “the strong demand backdrop and expectations that disruptions will ease is likely one reason that 2022 EPS estimates for these firms have been roughly unchanged.”
So, that’s the benign view — that voracious demand is mostly to “blame” for manufacturing delays. Assuming demand cools (but not too much, hopefully), supply can catch up, and things will normalize.
In the meantime, Kostin said the largest firms will likely lean on a variety of “mechanisms” to help. Some of those mechanisms bode poorly for the consumer, the most obvious being price hikes. Note too that cost controls can be bad to the extent they entail automation or layoffs. Workers are ultimately consumers after all. Other ideas include leveraging scale and simply switching suppliers.
“A key risk is that supply chain normalization takes longer than expected and that unmet demand today is not fully recouped in later quarters,” Kostin went on to caution.
Other key themes Goldman will watch for during earnings season include the impact of surging oil prices, rising labor costs and the slowdown in China. Apropos of everything mentioned above, the bank said that “the indirect impact on supply chains is likely a greater EPS risk than the direct effect from reduced end demand in China.”
As a reminder, consensus is looking for 27% EPS growth in Q3 (figure below), down markedly from Q2’s bonanza, which was the product of an anomalous comp and extreme uncertainty both on the part of analysts and management.
Although Goldman expects earnings will generally top consensus, they stated the obvious: “The frequency and magnitude of EPS beats will moderate” compared to the first half of the year. Not only is economic and profit momentum waning, but comps will get harder from here.
Still, Kostin wrote that “the bar for Q3 earnings results appears fairly low.” “Despite an aggregate 17% beat in Q2 S&P 500 EPS, bottom-up Q3 and Q4 estimates were only revised up by 3% since the start of Q2 earnings season,” he remarked.
Reshoring also implies substituting capital for labor as well. Think about labor shortages. Walk into many supermarkets in the US today and you will see self check out lanes. You will also see much more software/AI replacing labor at the up and down the skill scale. If a company does this than some of the cheap labor give up from reshoring will be saved by lower shipping costs and lower labor factor inputs. This also implies lower unit labor costs in the US as more tech and other capital goods are substituted for labor in the reshoring process.
… which seems like win win win, as long as we find a way to redistribute wealth…
27% increase in EPS — and that’s down from 2Q? I’ve said it before and will say it again: profit maximization is killing democratic capitalism.
Well, remember the comp. These aren’t sequential growth rates. Think about what was going on during Q2 last year.
My rather jaundiced view at the moment is more focused on duration rather than degree. When I first saw lumber collapsing after it’s Covid gyrations, I took it as an indication that supply chains were getting back to normal and (for example) that homebuilders were about to see margin improvement. Wrong. That depends on the complexity of supply chains. Lumber getting from a Canadian forest to a Lennar development in Dallas has a relatively trivial supply chain so it’s logical that lumber’s price reversion was “quick”. But a Samsung dishwasher heading for that same development has a horrendous chain stretching from Australian iron ore through semiconductors and global shipping and it’s still getting worse because the automakers are in crisis, etc. The fact that iron ore is starting to drop because of China is nice, but check back in a year or so to see if dishwasher supplies and pricing in US stores are back to normal. And good luck to those homebuilders and their margins (not to mention the Fed’s “transient” thesis).
In my mind, the issue for stocks isn’t that earnings will start horribly missing (degree), it’s that we’re just starting to appreciate how surprisingly long that earnings headwinds could last (duration). To the extent non-trivial reshoring, or even supply chain re-optimization, is actually occurring, then the associated, and rather opaque, earnings hit is decoupled from Covid and coupled instead to complexity. Covid cases can go to 0 tomorrow and it could still feel like eons before we’ve untangled dishwashers, figuratively speaking.
All value chains are complex in modern industry. Even a box of cereal requires farmers to grow the grain (and sugar), a firm to process the grain, a firm that makes boxes and another, perhaps, for the liners. Then there are the truckers that haul the grain, others that haul the many processed inputs, and finally truckers to haul the cereal itself. Cereal is a lousy product to haul, btw, because it is bulky and not very valuable with a high volume-to-weight ratio, making per-box trucking costs high. Then there is a huge shortage of drivers, causing rising wages, and oil is up, and that’s just cereal. For foreign products/inputs, container prices have quadrupled, making cheap clothing, for example, much more expensive, especially when delays are factored in. Ports are short of labor and drivers/trucks to haul the containers are also in short supply.
Virtually all business decisions involve tradeoffs. Globalization, off-shoring, just-in-time, labor and materials substitutions, etc, are all ways to cut costs, reduce required investments in fixed assets and inventory, hopefully leading to increased profits. When all these strategies are working perfectly we see those profits climb. However, any disruption in the complex chains supporting these strategies produces a Keystone Cop sort of crash where each of the steps is held up and starts crashing into the steps in front. What is happening is that our processes suffer from what system theoreticians know as a lack of “requisite variety.” Variety in resources combats the effects of disruption. Safety stocks of extra inventory, diversification of suppliers and other such practices buffer firms from disruptions. Of course, each safety step costs money and firms have gradually striped away these precautions to increase profits. Now we will all pay the price and if one takes into account the idea of striking a better balance between minimalism and safety from external shocks, I suspect price increases will not just be “transitory” as we move to create supporting variety,and remake our value chains. Notice how Toyota, an original just-in-time proponent, has bested GM in the most recent quarter because it increased its stock of critical microchips and was able to build and sell more cars than its rival.
BTW, H, this was a very good piece.