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.”

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4 thoughts on “Just Don’t Call It Optimism

  1. The real bellwether this cycle will be… T. Good old American Telephone & Telegraph. And they’ve already reported earnings, just no one seems to have noticed.

    Having now divested all of their media business, it’s a much simpler company now. So how did they do?

    Top line: beat
    Bottom line: beat
    New wireless subscriptions: big beat
    New fiber subs: big beat

    They even guided revenue projections for FY22 Up by about 10%. So how did T respond?

    Worst day since 2002.

    The only negative was a guide-down on FCF forecast. This guide-down was from 2 sources. 1) 5G rollout more expensive than originally planned. 2) increased slow/late/non payment from customers. Average customer payment time worsened by over 2 days. And that was the bombshell that sank the stock.

    Cellular service isn’t a discretionary expense anymore, and while there are cheaper options than AT&T, the phone companies are doing just fine.

    But their customers aren’t.

  2. I get ATT Internet and VOIP phone service. My internet is supposed to be 18-20meg service but within the last year I noticed one download coming in at 56k! Yesterday I was opening a video clip from a friend and it was downloading at a steady 2.1 meg. I live in a top 20 market and this is the best internet they can provide and they even cheat me on what they sell me. The phone only works 90% of the time. Sold my stock after 30 years.

  3. The mid/high income consumer entered 2022 with lots of extra cash, big housing and stock market gains, hot job market, pent-up demand, all driving spending. All that momentum won’t dissipate and reverse in just one or two quarters. Needs three and four.

    Have you ever had the disorienting feeling of hearing your friends buzzing about things you’ve known about for days or weeks? Agonizing over things your friends have never heard of?

    I’ll guess most readers of this site were expecting the economy to weaken and markets to fall, long before the average person did, and were tightening belts (unless you’re among those who don’t need to) when the average person was enthusiastically accelerating spending plans.

    Doesn’t mean you’re better than anyone else. They are doing their jobs and you are doing yours. Their jobs are to heal sick, teach children, balance books, design machines, raise family, fix leaks. Your job is to anticipate economic and financial things before they happen. They consume a few minutes of news a day (used to be more, but alas social media is not news). You’re consuming it 24/7 (who wakes up at 2 am every night to check Asian news? not them). They may be happier, healthier, better-adjusted, well-rounded, doing more for the planet and their fellow human, better people. You’re just an investor. (Don’t take this personally, ok? If you want to replace “you” with “me” that’s fine.)

    Getting back to the point, investors can be correctly anticipating consumers to pull back and earnings to slump, but incorrectly expecting it to all happen right away.

    I think we should watch the canaries. Who gets hit first in recessions? Lower income households. How are they behaving? Shifting back to food-at-home, driving less, buying less, delaying their bills, going increasingly delinquent.

    Look for that behavior to migrate “up”, and as it spreads to the mid/upper-mid income households that are the core customer for most consumer-facing businesses, look for misses and guide-downs to accelerate.

    Seasonally, 3Q is normally prime “harvest time” for misses/guidedowns.

    1. Following up, how large (in aggregate) is the canary?

      Let’s call US “low income” households those with less than $40K annual income, “middle income” those with $40K to $150K income, and “higher income” those with $150K or higher income. This (very) roughly corresponds to most definitions e.g. Pew Center. DG’s average customer income is about $40K, WMT’s $74K, COST $100K.

      Low income $150K: 14% of households, 42% of pretax income, 29% of expenditures, 80% of taxes paid, 74% of savings.

      From 2020 data https://www.bls.gov/cex/tables/calendar-year/aggregate-group-share.htm#cu-income

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