Economic growth accelerates against expectations
The stock market rally has lost momentum for a while as the investment landscape has turned dicey for equities. Interest rates that are like gravity for stocks have gone up as inflation expectations have risen again.
In this post, we will talk about how economic growth seems to be picking up again, which could re-accelerate inflation. Sure, there are also signs of a slowdown here and there, but nothing dramatic. Then we look at the earnings season in the US, which is practically a done deal. What is most interesting is how the forecasts for the future have evolved.
Economic growth accelerates again
In investment circles, a recession has been seen as an almost certain outcome, but the world's most anticipated downturn is yet to come. In recent weeks, a narrative has emerged in investment circles where economic growth is actually accelerating. The so-called soft or hard landing scenarios have been forgotten for the time being. The European Commission raised its economic growth forecast for this year to almost 1% as the energy crisis proved to be a false alarm. In the US, the GDP Now gauge expects GDP growth of over 2% in the first quarter.
In yesterday's macro, Inderes economist Marianne highlighted how employers seem to be hoarding workers because of the tight labor market. This is not exactly a sign of an incipient recession. It‘s worth remembering that it takes a while for tight monetary policy to be visible in the economy. The last time the policy rate was this high was in 2006, and the labor market only started to soften 18 months later.
For equities, a hot economy may not be the best news, as it's likely to fuel inflation and force central banks to continue their tight monetary policy stance. For a change, interest rate expectations have risen in recent weeks.
On the other hand, here and there you can see a softness in the economy. After all, interest rate curves are steeply inverted, suggesting problems in the economy somewhere within a couple of years.
In the US, banks' credit criteria are tightening further, according to a recent survey of loan officers. 45% of all banks are tightening lending conditions for small and medium-sized enterprises, and a third for consumer credit card loans. According to the survey, banks justify their reluctance to lend on the grounds of a weaker and uncertain economic situation and less risk appetite. As you can see from this graph, tighter lending conditions by banks are leading to a recession, as credit keeps the wheels of the economy turning.
This tightness is slightly reflected in the growth rate of bank credit. Bank lending in the US stands at just under 18 trillion and is growing at just over 5% a year, whereas during the pandemic heatwave, lending grew at over 10% per annum. In recessions, borrowing tends to slow down, yet the growth rate rarely turns negative on an annual basis. This has only happened in recent decades during the financial crisis, as this graph shows.
Elsewhere, global ocean freight giant Maersk from Denmark sees container traffic shrinking by as much as 2.5% this year as the global economy slows and the market returns to normal from its pandemic-era frenzy. Freight rates have normalized to the levels seen at the start of the pandemic, as this Bloomberg graph shows. Cargo companies were making record profits a moment ago. Maersk made a profit of over $30 billion last year, while this year's profit is expected to be in the ballpark of a few billion. However, investors should remember that during the pandemic it was the consumption of goods that went through the roof, and the normalization of that consumption doesn’t necessarily in itself signal a recession.
Summary of the earnings season
The earnings season for the US can practically be summed up already, as more than two thirds of the companies in the S&P 500 have reported their results. In this section, we will review the performance of the period at index level and what the forecasts for the coming years look like in the light of current data.
EPS forecasts are revised downwards in record numbers. This graph shows how large a proportion of all forecast changes are negative. The dramatic nature of the pattern is dulled by the fact that forecasts are systematically revised downwards as usual, and these cuts can be seen more as a return to normality.
Several analysts have lowered their expectations for the profitability of listed companies this year.
However, if you look at margin developments in this graph over a longer time horizon and projections for the coming years, in practice, margins are still projected to slip back to old records in the coming years. This despite inflation and the possibility of a subsequent economic slowdown... On the other hand, many companies—most famously the mega-techs—have recently started to streamline their operations, which supports the improvement in profitability.
The S&P 500 index is about to turn negative for the first time since the COVID pandemic. This graph shows the 12-month change in quarterly earnings per share.
Many investors think that shares directly track actual results and therefore shares should fall as results fall. I hate to break it to you, but that’s not the case.
At this point, it's worth pointing out again that although stocks follow results in the long run, they may move in a completely different direction in the short term, even for a few years. The present value of listed companies is the sum of their cash flows over their entire future life cycle. Discounting works on the logic of "one euro today is worth more than one euro tomorrow". Thus, stocks track these far-future projected cash flows, not one-year results. The correlation between one-year earnings performance and the stock market is close to zero.
Equities track slightly better the development of projected results one year ahead, but these two don't go hand in hand either. This graph shows the projected level of the S&P 500 index and the index's EPS 12 months ahead. In 2019, for example, shares rose even though results stagnated. The same trend has occurred in recent months. On the other hand, between 2014 and 2016, the S&P 500 index stagnated when results didn’t increase. The stock market is also driven by liquidity, sentiment and interest rate developments, especially in the short term. That's why it's not worth being too bearish about the results. But if the results crash for a prolonged period, it will be difficult for the stock market to rise.
This graph further shows how the EPS projections for 2022-2024 have evolved. As a result of the earnings season, the EPS forecast for the current year has fallen below last year's forecast. A return to earnings growth would follow in 2024, if optimistic forecasts are to be believed.
One more brief comment on the current performance level, which I have brought up before. The current results are based on record profitability, also measured by return on equity. The return on equity of the S&P 500 index, which expresses the ratio of net profit to equity of companies, hit a record high of 20% in a scorching environment during the pandemic. But looking at the longer-term development of ROE, the question arises whether the current level of profitability of listed companies is sustainable. Why wouldn't competition eat into profitability? However, different sectors shine in different environments. For example, the banking sector's return on equity is inflated by rising interest rates, while higher interest costs hurt debt-laden firms. The leading earnings monsters in the S&P 500 index, such as Microsoft or Apple, are very capital-intensive businesses, which somewhat undermines the use of this measure. Still, the return on capital has remained fairly stable over time and it's a useful indicator at index level. If the S&P 500's return on equity were normalized to, say, the average of the last 15-plus years (below 16%), the index's normal earnings per share would be $185, not the $220 it's today. The index trades at currently about 23 times this normalized result. I must admit that this is a fairly simple observation and there are many good reasons for the record profitability of listed companies as I have often said. Be that as it may, it’s still worth being a bit cautious about the sustainability of earnings and what assumptions you make about them when assessing the future earnings potential of equities.
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