Bears, Bulls And The People In-Between

It’s “premature to sound the all-clear,” Morgan Stanley’s Mike Wilson said, of US equities, which continue to look a lot like falling knives in his eyes.

Stocks rode a three-week win streak into July’s CPI report, which is expected to show price growth receded last month. Wilson’s message on falling inflation: “Be careful what you wish for.”

He cited market-based measures of inflation expectations in noting that from all appearances, “the bond market has quickly turned from a vigilante to a believer that the Fed will get inflation under control.” The bounce in US equities, he wrote, suggests stocks are likewise on board with the notion that inflation will ultimately be slain, clearing the way for the Fed to dial back its tightening campaign or even pause rate hikes, supporting valuations, which contracted by a third when equities collapsed into a bear market this year.

There are several problems with that thesis, Wilson suggested. First, profit forecasts are falling, even for this year and even for tech (figure below) and PMIs are too. Many strategists, Wilson among them, argue earnings estimates for 2023 remain far too high for a laundry list of reasons including elevated odds of a recession and margin pressure.

Although falling bond yields have bolstered long duration equities (e.g., tech), it’s far from obvious that any sort of aggressive re-rating makes sense. The Fed isn’t done hiking rates and according to Mary Daly, intends to keep them elevated for the foreseeable future. Multiples may trough before earnings, but the latter haven’t even begun to recede in earnest and barring an out-of-consensus policy pivot, the Fed has at least another 100bps worth of rate hikes in the pipeline.

As discussed here over the weekend, BofA expects aggregate S&P earnings to dive next year to just $200 in their base case. Goldman expects the same index-level EPS — in a recession scenario. The bank’s baseline is for EPS of $234. Bottom-up consensus is at $244 after estimates were trimmed by a little over 2% during a Q2 reporting season which, generally speaking, went better than expected.

Goldman’s Kostin continues to see margin forecasts as too optimistic. The bank said revenue growth will be 4% next year, but cut its net profit margin estimates on expectations for ongoing input cost pressure. Goldman sees 2023 margins contracting 25bps to 12%, 50bps below bottom-up consensus, and just short of last year’s levels (figure below).

Morgan’s Wilson noted that producer prices are rising far faster than consumer prices, on the way to calling forecasts for margin expansion in 2023 “unrealistic due to sticky cost pressures and receding demand.”

For Wilson, slower inflation could be bad for corporate profits. In the back half of 2020 and into 2021, “helicopter money” gave companies “outsized earnings power… as the newfound surge in demand came while the government was effectively subsidizing labor costs [leading] to unprecedented and unexpected operating leverage,” he said, before warning that “falling inflation will essentially have the exact opposite effect on profits that rising inflation did in 2020-21.”

In Wilson’s view, a “negative operating leverage cycle has just begun,” and “much as [consensus] underestimated the positive operating leverage as inflation rose,” analysts are likewise underestimating the snapback.

Morgan Stanley

Although corporate America is taking tentative steps to protect margins, July’s blockbuster jobs report suggests companies aren’t yet resorting to across-the-board job cuts. The hotter the labor market, the less likely a Fed pivot.

Assuming inflation peaked (and Wilson thinks it probably has), bonds may enjoy a sustainable reprieve and valuations could stabilize, notwithstanding the ongoing tightening impulse from the Fed. But peak inflation “won’t be good for profits,” Wilson warned.

“The next leg lower may have to wait until September when our negative operating leverage thesis is better reflected in earnings estimates,” he wrote. But with multiples already “stretched” again thanks to the recent decline in yields, Morgan Stanley thinks “the best part of the rally is over.”

Meanwhile, JPMorgan’s Mislav Matejka said global equity valuations appear attractive both in absolute terms and relative to bonds. Although earnings revisions have turned negative and will probably be reset, the pullback should be shallow thanks to elevated corporate pricing power, ongoing revenue growth and financing costs that are perhaps less onerous than inflation suggests.

In JPMorgan’s view, the vaunted “wealth effect” is still in play. US home prices should be resilient given still low inventories, the labor market is strong and consumers still have excess savings left over from the pandemic. The risk-reward for equities, Matejka contends, is improving into year-end.

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6 thoughts on “Bears, Bulls And The People In-Between

  1. I think Wilson’s view of the current and likely future negative operating leverage situation is on the money and if there is a recession, travel, hospitality, hospitals and clinics, and other high fixed cost industries will get creamed.

    1. The Intercept piece wasn’t quite the ‘gotcha’ their headline made out. See It was a client research note rather than an internal memo, and BofA ‘hopes’ the ratio of job openings to unemployed comes down to more normal highs, as the Fed are hoping as well. Larry Summers thinks that is wishful thinking, and the article points reminds that he thinks unemployment ‘needs’ to be, say 7.5% for 2 years, to get inflation under control.

      1. Exactly. See my comment below. That article in The Intercept is a terrible misrepresentation. I didn’t read their reporting before, but I surely won’t now. That article seems to reflect a total lack of editorial oversight or else a total lack of editorial competence, with the latter being far worse than the former.

    2. That article in The Intercept is wildly disingenuous and I can’t believe that BofA has let that reporting stand. That article is (and I really don’t know another adjective here) wildly irresponsible.

      That is not an “internal memo.” It’s a client note. And Harris isn’t “an executive.” He’s their chief economist.

      There is nothing — I repeat nothing — unusual about that note, and the fact that The Intercept published a screenshot of it as though it’s some kind of top secret document reflects an embarrassing lack of knowledge on their part. That note was probably sent out to every financial media outlet on the planet who’s on BofA’s media distribution list.

      Again, I want to emphasize to readers in the strongest possible terms: That article that the comment above references is totally ridiculous and reflects a complete lack of understanding on The Intercept’s part vis-a-vis sell-side research and, frankly, the macro economic debate in general.

      In my opinion, it should be retracted.

  2. Good summary of the 3 houses’ views.

    On the reasoning of JPM the outlier, am trying, and struggling a bit, to imagine what could make their arguments prescient 6-12 months down the road: “elevated corporate pricing power” & “ongoing revenue growth”, apparently have to be linked to “consumers still have excess savings left over from the pandemic” (which is at odds with worsening consumer sentiments, except for segments catering to high-income households?) and “the labor market is strong” (forward looking basis, it’ll be premised on soft-ish landing?)? As for “financing costs that are perhaps less onerous than inflation suggests” and “US home prices should be resilient given still low inventories”, seem premised on the conviction that Fed wouldn’t go too restrictive (say FFR>4.0%) and stay there too long? And it all boils down to the judgment that inflation will be less pressing an issue a year from now, to which Pozsar said one is too optimistic; while Wilson said slowing inflation will pressure profits… 1 year from now, who will be right?

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