Just Don’t Call It Optimism

I’m sympathetic to the possibility that a true reckoning for US corporate profits may still be one (or two) quarters away.

On any number of occasions this year, I insisted the moment of truth was likely imminent, where that meant Q2 earnings season, currently underway. I haven’t abandoned that thesis. Any compendium of management commentary derived from this quarter’s calls would be replete with references to macro challenges. Bank CEOs (including Jamie Dimon and Jane Fraser) were generally constructive, but there’s no sense in which “all’s well.” Just ask Snap, or Seagate or any of the major US companies who’ve stopped hiring.

That said, there’s scant evidence, so far anyway, that Q2 reporting season will go down as singularly disastrous. The figure (below) gives you some context for where things stood as of July 22.

More companies are reporting negative surprises, both in absolute terms and measured by misses of at least one standard deviation. At the same time, the percentage of in-line reports is rising, and positive surprises are trending lower.

It’s far too early to draw conclusions, though. Just 21% of companies have reported, and a lot hangs on mega-cap tech.

Headed into earnings, bottom-up consensus was mercilessly derided for what some described as a “deer-in-headlights” dynamic, wherein company analysts were simply unable to incorporate, let alone process, the sheer amount of indeterminacy embedded in what it’s probably fair to call the most fraught macro backdrop in modern history.

Another argument says that company analysts, as a community, understood something the top-down crowd didn’t fully appreciate — namely that the buoyancy of aggregate profit forecasts was in part attributable to energy and materials, and anyway wasn’t evidence of complacency.

Some aspects of that debate admit of quantification, but I’ll refrain in favor of simply suggesting (again) that the modest revision to forward profits illustrated in the figure (above) is wholly insufficient to account for the current level of macro uncertainty, irrespective of caveats.

It’s possible, for example, that commodity prices could temporarily plunge in the face of a deep recession in Europe and shallower, albeit still irksome, downturns in other advanced economies. That would weigh on energy and materials. If you’re inclined to say such things are unknowable, I’d tell you that’s precisely the point.

Notably, the dollar’s epic 2022 flex will almost surely manifest in additional top-line disappointments. “Periods of dollar strength have historically coincided with disappointing sales results from S&P 500 companies, suggesting analysts consistently fail to account for large currency moves when forecasting sales,” Goldman’s David Kostin said. The figure (below) illustrates the point.

Historically, 20% of S&P 500 companies miss on the top line every quarter by a standard deviation or more. So far, that figure is 22% for Q2 2022. Just eight of 76 Info Tech companies have reported. Info Tech has the most international exposure, deriving almost 60% of revenues from abroad. Nasdaq 100 companies get almost half of their revenue from outside the country, compared to less than a third for the S&P and just a fifth for the Russell 2000.

At the least, that’s something to look out for. The top line is at risk from slower growth and a stronger dollar, while the list of margin headwinds is as long as it is familiar. “All else equal, a 10% appreciation of the trade-weighted dollar would reduce index-level earnings by 2-3%,” Kostin wrote, adding that “for context, a 1pp change in US and global real GDP growth would shift EPS by 3.5% and 0.5%, respectively.”

I’d also note, as Goldman did, that US shares with exposure to Europe are probably at risk given the relatively high odds of recession, and the same goes for China, where the outlook remains tenuous, to put it nicely. Goldman puts the odds of a recession in Europe at 50% over the next 12 months and now sees the Chinese economy expanding just 3.3% in 2022.

None of the above is meant as “doom and gloom,” per se. As I alluded to here at the outset, I’m actually a bit less pessimistic about US corporate profits now than I was a few weeks ago. But “less pessimistic” isn’t the same as optimism. And unless Jerome Powell loses his nerve entirely, there’s a lot of Fed hiking left to do.

“Consensus was very slow to price in the inflation shock and rates shock but has been very quick to price in a recession shock,” BofA’s Michael Hartnett said. “There are recession signals [including] claims heading higher, weaker housing and advertising spend cracking, but big data like payrolls and retail sales are far from allowing the Fed to tone it down.”