One constant in an ever-changing market narrative is the notion that equities are one of, if not the, best inflation hedge.
Stocks, the story goes, are a claim on nominal growth. Sure, you could buy some land or invest in commodities, but most everyday people aren’t in the market for a “portfolio” of land, and neither are the majority of investors well positioned to speculate in raw materials via futures. So, “dumb” equities it is.
But there’s a problem. Stock prices ultimately follow corporate profits. And profits are a function of revenue and costs. If inflation rises too far, too fast, consumers’ capacity to make discretionary purchases is diminished, barring a commensurate increase in the wages they earn when they trade their consumer hat for their labor boots. But what, ultimately, is labor? It’s an input cost. Of course, across-the-board inflation is pushing up the price of other inputs too. And that’s inextricably bound up with rising labor costs. Why? Because those other inputs are usually linked to raw materials, and at the end of the day, surging commodity prices crimp consumer demand for non-essentials.
The final act in that perniciously self-referential play is captured poignantly in the two simple figures (below) from Morgan Stanley’s Mike Wilson. Absent some circuit breaker, this conjuncture risks dead-ending in demand destruction or margin compression. For Wilson, the latter outcome isn’t priced into US equities.
“While we appreciate how inflation can be good for nominal GDP and therefore revenue growth, we think inflation is no longer a net positive for earnings growth given the impact on costs that are now showing up in margins,” Wilson wrote this week. “The war in Ukraine has led to a spike in energy and food costs which serve as nothing more than a tax on a consumer that is already struggling with high inflation.”
The April vintage of BofA’s Global Fund Manager survey found global profit expectations deteriorating to a net -63%, the worst levels since March of 2020 (figure below).
“Other previous instances of such low levels include the collapse of LTCM, bursting of the Dotcom bubble, Lehman bankruptcy and COVID,” the bank’s Michael Hartnett remarked.
Morgan’s Wilson sees earnings revisions breadth turning “outright negative” this reporting season, and while he conceded that doesn’t necessarily mean forward earnings will decline sharply, it’s “typically a sign that forward earnings estimates are going to decelerate or at least consolidate sideways.”
One thing we can say with something approaching certainty is that negative earnings revisions breadth is bad news for stocks (figure on the left, below).
Importantly, Wilson isn’t forecasting the apocalypse here. For example, the figure on the right (above) uses a simple regression and shows fair value for the S&P if revisions breadth were to deteriorate consistent with late 2015/2016, a period defined by the aftershocks of an overnight yuan devaluation and an attendant mini-downturn. That period also marked the onset of the Fed’s last hiking cycle. Recall that Janet Yellen delayed liftoff to December of 2015 from an assumed September start due in part to the fallout from the August yuan drama. That episode wasn’t pleasant, but it wasn’t the end of the world either.
“Similar to that period, we think the next quarter or two will constitute a growth moderation but not an economic recession,” Wilson wrote, adding that “a fall to similar levels on earnings revisions points to ~4,000 price at the index level,” which he reminded clients is a fair value price level the bank has also arrived at using different modeling approaches.
I’d note, in closing, that Wilson isn’t alone in being skeptical of margin expectations for 2022. While analysts have generally acquiesced to the likelihood of crimped profitability in first quarter results, consensus expects net margins to recover in the back half of the year, consistent with the idea that inflation should ebb along with labor market stress.
That’s an optimistic assumption, especially when you consider, as Wilson highlights, that “consensus actually expects higher net margins for the balance of 2022 than what we saw at the end of last year” for cyclical sectors including Consumer Discretionary, which is (arguably) the last place you’d want to be in a macro environment like the one we’re in right now.
Respondents to the BofA survey apparently agreed. Fund managers were more bearish on Discretionary than any other sector.
For me, the difficulty lies in trying to estimate to what extent the market has already discounted this negative impact and is looking forward to say 2023 onwards. Spy fell approximately 15% peak to trough already which, while not equal to the nice round 20% typically accompanying such conditions (perhaps due to the stubbornness of aapl and to a lesser extent msft stocks), is still meaningful.
Further, I believe two of the previous four mentioned dates saw meaningfully positive 12 month forward returns (98 and 2020).
With the index having returned to around -7% from ath and sentiment (at least as measured by cnn’s fear and greed index) having normalized, risks are slightly to the downside imo. AAII sentiment is extremely bearish, yet actual positioning in terms of breadth and equity allocations doesn’t seem nearly as bearish. My best guess is this is due to investors’ simplistic view that inflation is positive for equities.
I have been impressed at how well corporate credit spreads have been holding up thus far (…notwithstanding the pop after the Invasion, roughly half of which has been retraced).
H-Man, not being one to dumb it down but how does raging inflation, rising interest rates, and current Ukrainian conflict provide any support for equities? I guess that is why God invented rose colored glasses.
The reason high yield spreads have held up is due to the fact that the energy weight in the index is approximately 25% and their are probably other commodity related companies in it as well. One thought on Wilson’s take, which I am sympathetic to is that if equities do have a date with 4000 it will have to occur at a time when sentiment on the economy as shown above is pretty dire and sentiment in the equity market is also dire as shown by BAML Bull / Bear or AAII bulls. Also, it can be shown that typically margins do not compress (in aggregate) until right before recesson. This idea that higher costs at some point do not get passed on to the consumer which thereby compresses margins is an idea which does not stand up well to scrutiny. Sure, if recession is about to happen, you see it, but unless that is dead certain, I would not expect it.