Headed into Q3 reporting season in the US, the narrative among many top-down strategists sounded a lot like it did prior to Q2 earnings.
A “reckoning” was imminent. There’s only so long profits can hold up in the face of gale-force margin headwinds from elevated raw materials costs to soaring wage bills to higher interest rates. At the same time, the consumer was destined to retrench, as generationally high inflation and economic uncertainly reflected in lackluster sentiment finally manifested in demand destruction.
So far, it’s not working out that way. Bank earnings were better than feared despite a steep decline in IB revenue, and according to Jamie Dimon and Brian Moynihan, the US consumer is holding up well — very well, even, under the circumstances. And, much like Q2, the bar was preemptively lowered. In June, Q3 profits were seen rising 10%. Those expectations were tempered to just 2.2%, leaving the door open to another ostensible “beat” from corporate America.
If you think the Fed’s largely priced in (and it could very well be that ~5% terminal rate pricing was the peak), and you don’t believe the economy is set to fall off a cliff, you could argue that we’re set up for a “here we go again” moment.
“The ‘Q3 earnings as the next (negative) shoe to drop for equities’ thesis is again treading on thin ice into the meat of earnings season next week, where similar to what we saw in Q2 (which precipitated and juiced the summer stock rally), bank earnings showed the US consumer refuses to crack, with credit card delinquencies stuck near the lows and net charge-off rates declining to historic lows themselves, despite card spending increases,” Nomura’s Charlie McElligott said Tuesday.
The figure (above) is a rather stark reminder of just how anomalous the summer rally really was. The S&P had one of its best earnings season rallies on record.
Crucially, inflation is still working in favor of corporate profits. Price growth “continues to act as a tailwind for earnings via pricing power,” McElligott went on to say, noting that resilient consumers “continue to ‘make it work,'” where that means “digesting price increases” so that good corporate citizens don’t have to eat it on the bottom line.
How sustainable that is is anyone’s guess. For now, though, the combination of higher inflation in general, but cooling commodity prices, has created a “sweet spot” of sorts for corporate margins, much as banks are enjoying what Bloomberg described as a “Goldilocks” environment for credit cards. “Spending is up [and] customers are finally borrowing again… just as the Fed is raising interest rates, bolstering the net interest income banks collect,” Jennifer Surane wrote this week. “But because consumers are still sitting on so much cash, delinquencies remain freakishly low.”
The result, McElligott remarked, is “Schrödinger’s Economy.” “With inflation where it is, US nominal GDP is over 10%, so top line growth stays spicy, which in conjunction with wage growth at record highs and overall employment remaining hot, continues this ‘Schrödinger’s Economy’ tension [where] current dynamics show still relatively strong conditions, but awkwardly juxtaposed against consensus ‘hard landing / recession’ forwards in the market,” he said.
All to say, inflation isn’t going away any time soon. I could see it abate to the 4-5% range for 3-9 months (higher YoY comps, supply chain fixing, etc) before coming back again driven by various US Treasury interventions (Fed will still be in “saving face” mode) to stem the liquidity issues in the global bond markets and a rebound in equities (possible bull market) in early 2023.
When it comes back, that’s when things get “really interesting”.
Should have pulled the trigger on that call option yesterday 🙁
Two call options actually, just so the algos “know” I’m not retail :smirk:
A possible scenario is economy and earnings stronger for longer, inflation higher for longer, Fed tighter for longer, and this continues until something breaks.
We could continue with this pattern of bear rallies and pullbacks, lower highs and lower lows.
Even if economic indicators and earnings are not going down as fast as the most bearish expect, they are still going down,
Index levels and investor actions have not yet reached capitulation levels. I know sentiment has been ugly, but how much actual panic have you seen?
Inflation is not slowing meaningfully. Lags and stickiness (labor, wage, shelter, etc) suggest accelerated slowing might not show up until 2023, possibly mid-year.
Absent evident impending or actual breakage, the Fed may be loath to call time on tightening when inflation hasn’t shown signs of easing.
My working theory is a 4Q rally (3900? 4100?) then new lows.
With so many short term options in play, I expect VIX to get more expensive relative to historical volatility. This leaves the index drifting intra-day in annoyingly tight bounds for a couple of months.
I’ve been trying to take a personal budget based way of thinking about inflation. Thirty to thirty-five percent of an average person’s expenditures, give or take, are spent on shelter. Once raised, rents will not go lower for folks already renting. Other costs of shelter like heat, light, power and taxes are also going to to remain sticky for now and the foreseeable future. Home prices themselves may start to flow, but higher rates will keep monthly payments rising for a good while. On a cash basis those of us lucky enough to own our homes will still see rising utilities, taxes and maintenance expenses, although the house itself is not a cash drain. So, for most people, shelter-based inflation is mostly sticky and that’s at least a third of the budget for most folks. Food makes up 10-15% of the budget for most folks. I think food will keep rising for now, faster than housing, but it will not be as sticky. Clothing has also been rising and is labor intensive. The more of this we bring onshore, the harder it will be to get prices down. Clothing outlays vary, but for families with kids, it will not be easy to manage in the short-run. Medical care, while not a huge cost for many, is also a cost for all of us who are aging. This cost is rising and will not fall, probably ever. Transportation is a combination expense. This has made up less of the budget for those working from home since Covid because of fewer miles driven but insurance is up, gas is up, and cars won’t get cheaper on average as they become more complex. The conclusion I come to, on a back-of-the-envelope analysis is that for most normal, average folks, 65-70% of our budgets are going to remain locked in to items that are super sticky and interest rates aren’t going to change that prospect any time soon. People can change the quarter of their spending that is more discretionary but they will have trouble actually doing it. Perhaps the rise in prices can be brought back to 2 or 3% in five years, but by the time we get there we will be able to see the pain.
Great post.