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Good morning. Over the last 10 days or so, there has been one of those little shifts in markets that is just big enough to be noticeable and just logical enough to look meaningful.
The move appears to have been kicked off by three pieces of strong economic data: the apparently dovish Fed meeting on the first of the month, and the strong jobs report and the big bounce in the ISM services survey, both a couple of days later. The immediate response to these events did not look like a standard good-news-is-bad-news-in-a-rate-hiking-cycle move down, but over time the mood changed. As futures-market interest rate expectations rise, the dollar is firming up. The rate-sensitive Nasdaq is down 4 per cent since the third, and the speculative-risk proxy Ark Innovation ETF is off 13 per cent. Bond yields have ticked up. Flows into equity funds were negative last week for the first time after being strong during the preceding two. Emerging markets flows reversed too.
Probably this is just a blip within the 2023 risk rally, but worth watching as this week unfolds. Send us your thoughts: [email protected] and [email protected]
US earnings season: recession hints?
The US economy is sending mixed signals. As we wrote last week, there is — to pick three representative examples — a strong labour market, a weak housing market and mixed signals on credit availability. It makes sense that the picture would be more ambiguous than normal. The big pandemic shift from goods to services spending has yet to unwind and the monetary and fiscal stimulus, including direct support for consumers, still echoes across the economy. What market watchers are trying to do, with very limited success, is make out a cyclical pattern beneath these two big shocks. Are we heading towards a recession, as the deeply inverted yield curve implies, or is this time different?
A close look at fourth-quarter earnings provides a few clues. Two-thirds of the S&P 500 has reported results so far. And the aggregate picture — fleshed out nicely in FactSet’s useful Earnings Insight report (here) — is that revenue growth is slowing, margins are compressing, and earnings are falling. Among the S&P companies that have reported, sales are up 4.6 per cent from a year ago, and earnings are down 4.9 per cent. Net profit margins therefore compressed by a full percentage point, from 12.4 a year ago to 11.4 today. Unhedged (and a whole lot of other people) said this had to happen, and now it’s happening.
What is the source of the pressure? It will be hard, until reporting season is complete, to tease out how much of the net margin tightening comes down to higher interest expense, but given how many big companies locked in low rates when they could, it’s very likely that what we are seeing is operating margins coming down.
Savita Subramanian of Bank of America argues that, historically, the key factor driving margins has been the rise and fall of sales, and the same is happening today:
Analytically, and at the aggregate level, the story is extremely simple: wage and input costs are now growing faster than sales:
The link between the margin squeeze and the economy is, again, simple: companies cut costs to support margins, this means firing people, and that weakens aggregate demand. From high altitude, then, it looks like earnings are hinting at recession.
The problem is that as you get closer the picture becomes harder to read. Sector performance varies a lot. Margins are widening in the energy, real estate, industrials and utilities sectors. In information technology and consumer discretionary, almost half of companies are reporting widening margins. Some but not all of the dispersion can be explained by the goods weak/services strong split. In services, airlines are doing very well, so are hotels and restaurants. Weak earnings from the biggest tech companies (namely Alphabet, Meta, and Amazon) explain much of the decline in the tech and communications sector, which, like the surge in services spending, seems like a pandemic effect.
Completely detached from those pandemic overhangs, though, high capital expenditure is helping industrials companies, from machinery to aerospace. This is hardly suggestive of impending recession. Subramanian thinks that reshoring, high labour costs and an ageing capital stock is all but forcing companies to splash out on capital expenditure, but it seems to me that management teams could look past all this if they were properly worried about a downturn.
My unsatisfying conclusion on earnings season, then, is that I can’t quite see past the pandemic noise to make out a cyclical signal. The news in aggregate is not great, but it’s hard to make out if it is outright bad.
Meanwhile, in Europe . . .
Europe earnings aren’t looking too bad. So far, European companies are squeaking out 4.2 per cent earnings growth in the fourth quarter, compared to shrinking profits across the US, Japan and emerging markets.
Europe’s improbable source of strength: financials. You can hear it from the likes of BNP Paribas and UniCredit raising profit targets and projecting confidence. Binky Chadha and Parag Thatte of Deutsche Bank calculate that Europe financials are contributing 4.1 percentage points to aggregate earnings growth — making the difference between modest growth and none at all. By contrast, financials dragged down profit growth most everywhere else.
One crucial tailwind has been brighter economic prospects freeing up money once set aside for a recession in Europe, notes Simon Peters, a portfolio manager at Algebris Investments:
European banks have held on to substantial, unused Covid provisions on their balance sheets, as well as making significant precautionary provisions last year in anticipation of the ‘obvious’ recession that was thought to be coming at the end of 2022. Slow or no growth looks likely but it appears that a deep, long recession has largely been avoided, as energy has not needed to be rationed. The huge provisions built up will increasingly be fed back into bank profits this year.
Might this already be priced into stocks, though? Europe financials have had a good four months of outperformance, but that’s stalled since late January:
More broadly, too, European equities’ outperformance versus the US has come off the boil:
A sterner Fed could be to blame, as higher rate expectations boost the dollar, weighing on ex-US equities. But we’re not sure quite what to make of it yet. More on this later in the week, and if you have a hunch, do let us know.
One good read
Social scientists are no better at making predictions about social trends than simple algorithms. This is not surprising, and it applies to investors, too, probably to an even more extreme degree. But the academics’ predictions improve if they have specific expertise in the prediction domain, are interdisciplinary, stick to simple models and follow the data. There is hope. Hat tip to (who else?) Phillip Tetlock for the pointer.
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