Hope is not a process
Investors bracing for a challenging third-quarter earnings season.
The S&P 500 has plunged more than 27% so far this year, hitting a new 52-week low Thursday and revisiting levels not seen since the presidential election of November 2020. This is the equity market’s worst year-to-date performance since the bursting of the housing bubble and the global financial crisis in 2008. The S&P has now technically retraced half of the powerful 120% rally we enjoyed from the pandemic trough on March 23, 2020, to the record peak on Jan. 4, 2022, and we may not be done. If 3,500 fails to hold technically, the S&P could continue to decline to 3,200, another 11% lower.
Moreover, benchmark 10-year Treasury yields more than doubled from 1.5% at the start the year and 2.5% in early August to a new 14-year high at 4.02% on Friday. With 2-year Treasuries yielding 4.5%, that implies that the important 2/10 yield curve spread is now inverted by 50 basis points, which the bond vigilantes believe reflects the growing risk of recession next year. The volatility index (VIX) has spiked from 20 to 35 over the past two months.
Financial markets are stressed on the merits Let’s start with inflation, as core CPI inflation hit a new 40-year high of 6.6% in September 2020, and the 1-year inflation component of the preliminary Michigan Sentiment Index for October leapt from 4.7% to 5.1%. Elevated wages are sticky, shelter costs are sustainable at record highs into next year, and we expect energy costs to surge again in coming months.
As a result, the Federal Reserve will likely continue hiking interest rates at an aggressive pace for the foreseeable future. Our best guess at this time is a fourth consecutive 75 basis-point rate hike on Nov. 2 and a possible half-point hike on Dec. 14, which would take the fed funds target rate up to a range of 4.25% to 4.5% by year-end.
Earnings season a challenge The third-quarter corporate profit season is just starting, and FactSet is expecting a 3.3% year-over-year (y/y) increase, down from a 9.9% expected gain at the beginning of the quarter. That compares with an outsized 39% y/y gain in the third quarter of 2021, down sharply from 88% in last year’s second quarter. Comparisons will continue to get easier in the fourth quarter, as growth falls to a y/y gain of 27%.
Guidance poor Top-line revenues could be relatively solid in the third quarter, in part because of the continued surge in inflation. But profit margins should be under considerable pressure for the third consecutive quarter, due to elevated costs for labor, commodities, transportation and warehousing. Worker productivity could remain at record lows as well, due to the influx of new, inexperienced employees this year.
Inventory concerns While the West Coast port logjam is certainly easing, that has created a new set of inventory problems. For many stores, the merchandise that’s now arriving in stores was ordered more than a year ago. Customer preferences have shifted from goods to services, and some are reluctant to meet the higher, inflation-impacted retail prices. Moreover, the personal savings rate has plunged from an artificially elevated 26.3% in March 2021 (thanks to overly generous fiscal stimulus) to a 14-year low of 3.5% in August 2022. (The average savings rate over the past 30 years is 6.7%.) Companies are aggressively cutting prices to reduced bloated inventory, which is impairing profit margins and earnings growth.
Retail activity slowed during the third quarter Nominal retail sales in September were unchanged, compared with a robust 1.0% month-over-month (m/m) increase in June, at the very start of the important Back-to-School (BTS) season. So we now know that BTS 2022 sales (from June through September, inclusive) rose a healthy 9.1% y/y, but that pace is roughly half the outsized 16.4% gain registered during BTS 2021. (BTS sales rose an average of 3.7% over the previous five years.) Because BTS sales are highly correlated with Christmas sales, it appears that holiday sales this year might rise only 7-9%, down from 16.3% in 2021.
Dollar strength hurts exports Because of the Fed’s aggressive tightening strategy and the relative strength of the U.S. economy compared with our foreign trading partners over the past two years, the euro at 0.97 to the U.S. dollar is at a 20-year low, down 22%; the British pound at 1.11 to the dollar is at a 37-year low, down 27%; and the Japanese yen at 148 to the dollar is at a 32-year low, down 45%. That makes domestic goods more expensive, and according to our research friends at Credit Suisse, every 8% increase in the dollar versus a foreign currency negatively impacts earnings by 1%. So large-cap multinational companies, such as technology, which generate half to two-thirds of profits from overseas, could experience an additional 3-6% hit to earnings due to negative currency translation.
EPS estimates at risk in 2023? Given these concerns, our full-year S&P 500 earnings-per-share (EPS) estimate of $230 in 2023 (versus our estimate of $220 in 2022 and $209 in 2021) could be at risk, depending upon how poor the current earning season turns out and how cautious management guidance is given the lack of visibility. Midterm elections on Nov. 8 could be an important piece of this puzzle, as investors generally prefer divided government and gridlock. With the consensus estimate for 2023 at just under $250, if the economy falls into recession next year, a cut to $200 may be directionally appropriate, which could fuel the next leg down in stocks.
Keep playing defense We continue to advise investors to hunker down, seek to preserve capital, and deploy a defensive investment strategy now, with a large overweight in cash and a modest equity underweight concentrated in relatively cheaper, less-risky value stocks that have the potential for higher dividend-yield support.