by Franklin J. Parker, CFA
The Summary
- Rather than giving investors a sense of clarity, last week’s economic data muddied the water. Job figures came in much stronger than expected and the unemployment rate ticked down. Factory orders also came in stronger than expected. Couple that with generally stronger earnings (and guidance) than many expected, and it appears the economy is not as fragile as previously believed.
- Inflation is, of course, still a major problem, and the Fed’s ongoing effort to get it under control has created a “good news is bad news” scenario. As good economic news posts, investors increase their odds of a more aggressive Federal Reserve thereby pushing prices lower. We have gotten some reprieve from this effect, however, as Powell has led markets to believe that the Fed will take a pause allow their recent moves to work their way through the economy.
- About 90% of the S&P 500 companies have reported earnings, so the bulk of earnings season is now behind us. It looks like companies have grown earnings by about 7%, which is higher than the 4% initially expected. Almost more important, however, has been updated guidance. Negative guidance is below the five-year average, and companies are expecting to deliver more profit growth (albeit much slower) through the end of the year.
The Details
There is lots of talk about recession, the Fed, and corporate earnings. Let’s dig into the role each of these play in pushing market prices around.
The Fed. The role of the US central bank in determining market prices can be difficult to grasp, and that is partly because there are many nuanced and sometimes arcane ways Fed policy translates into market prices. At a high level, however, the Fed’s actions affect valuations—the multiple investors are willing to pay for every $1 in profit. When policy is “easy” (low rates, creating money), valuations are high. When policy is “tight” (rates are higher, destroying money), valuations are low.
To overcome the headwind of shrinking valuations, companies must grow earnings to push prices higher.
Recession. It may seem obvious to say, but recessions are usually bad for market prices—but understanding why is important in this unusual economic environment. Typically recessions destroy demand and thus corporate profits. When profits evaporate, there is a constraint on cash and companies have difficulty paying their bills.
If we are in a recession today, the fact that corporate profits are growing (and expected to continue growing) makes it far less scary than a “normal” recession. The variable to watch is consumer spending. If that begins to contract, companies may begin having trouble.
Profits. Ultimately, corporate profits (and the expectation thereof) are what drive prices. Lower profits lowers prices and vice versa. The worry surrounding inflation is that it eats into profits (or curtails consumers’ ability to spend). The concern of higher interest rates is that is leads to higher borrowing costs, lowering a company’s viability and ability to expand. All similar concerns are some derivative of corporate profit.
Many economic forces are at work today, but breaking them down into the two basic components helps us wrap our heads around the endless data points and news items that can otherwise swamp our thinking.
Keep it simple — most things affect either valuations or profits.
Chart of the Week
Analysts have generally revised their earnings projections down for the rest of 2022 and 2023, but many are still forecasting earnings growth, despite worries of higher rates and inflation, as this week’s chart shows. A month ago, analysts expected 2022 to deliver earnings growth of 9.5%, whereas they now expect 8.1%. Higher earnings are better, but despite all of the talk of recession corporate profits are expected to continue rising.
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