- We believe high inflation and rising interest rates have impacted spending trends, leaving earnings estimates vulnerable to downside revision.
- We believe the Fed will continue to raise rates throughout the remainder of 2022 even as the economy slows.
- Our strategies remain underweight equity.
Most of us are skeptical when we hear the phrase “this time is different,” but as we approach the earnings reporting period for the second quarter of 2022, we believe we may be facing one of those times. Throughout 2021, Wall Street grew accustomed to corporate earnings and revenues exceeding expectations. Quarterly reporting periods carried few blockbuster negative surprises, and earnings estimates steadily moved higher. The rapid decline in earnings in 2020, followed by the pronounced ‘V-shaped’ recovery starting in the spring of 2021, represented a rare, dramatic earnings recovery.
The speed with which corporate earnings returned to pre-pandemic levels was rapid enough that it may have created complacency that earnings growth would normalize to a mid-to-high single digit upward trend. To date, estimates for calendar 2022 are little changed since the beginning of the year. However, economically, plenty has changed since those original forecasts were made.
Consider the Following:
Everything costs more: Despite some optimistic forecasts that inflation may have peaked, this week’s release of the June Consumer Price Index (CPI) will likely continue to show inflation’s tenacity. Current consensus is for CPI to increase by 8.8% compared to last year’s rate. The optimism stems from the recent sell-off in commodities and gasoline prices trending lower. In contrast, food prices continue to move higher. In late June, the United States Department of Agriculture (USDA) raised its forecast for food inflation this year, projecting that supermarket prices will increase between 8.5%-9.5% this year. Goods such as poultry, eggs, and bakery are likely to see double-digit price increases.
Consumer sentiment has plunged, and spending habits are changing: One of the bright spots of the economic recovery has been the strength of the US consumer. Despite mixed readings in sentiment for much of the past year, the continued strength of retail sales supported the idea that consumers were still spending even if they were worried.
However, the most recent University of Michigan Index of Consumer Sentiment fell to a record low in June as elevated prices for food, gas, and other goods and services took a toll on how people feel about the economy. Last week’s release of ISM’s Services Purchasing Manager Index (PMI) data revealed that consumers are shifting purchases to essentials and away from discretionary items, in our opinion. Also, in the most recent first quarter Gross Domestic Product (GDP) revision, the Commerce Department revised consumer spending significantly lower from 3.1% to 1.8% (see chart, above).
Higher interest rates will dampen spending: Interest rates are headed meaningfully higher than what was expected at the beginning of the year. The initial expectations for two to three rate hikes fell by the wayside as the Federal Reserve (Fed) turned decidedly hawkish in response to rapidly rising inflation. The release of the minutes from the June meeting confirmed the possibility of a 50 or 75 basis point (bp) rate hike in July. The strength in recent employment data suggests to us inflationary wage pressure, making the 75bp hike in July more likely. Additionally, the minutes revealed that an even more restrictive stance would be appropriate if inflation remains elevated. Higher rates have a ripple effect through the economy and can act as headwinds for business and consumers alike as the cost of business loans, car loans, and mortgages impact spending plans.
Business enthusiasm has fallen dramatically: Corporate sentiment, as evidenced by both the Conference Board Measure of CEO Confidence and the National Federation of Independent Businesses Small Business Index, has sunk to record lows. The June report from the Conference Board painted a dim picture with over 60% of those surveyed saying that business conditions had worsened in the second quarter when compared to the first. Additionally, over 50% expect the economy to go into a short recession. The data compiled from the nation’s small business leaders echoed the grim outlook as the share of owners expecting better business conditions over the next six months hit a record low. Lowered levels of confidence about the future could alter plans for hiring and business expansion.
By the numbers: The Standard & Poor 500 (S&P 500) is now down more than 17% year-to-date, but earnings estimate for 2022 have not meaningfully deteriorated from levels projected at the beginning of the year, despite the economic headwinds and earnings warnings from some high-profile companies. Over the past three months, 102 companies in the S&P 500 have issued earnings guidance for the second quarter, with nearly 70% lowering expectations. We believe this is the quarter that could be different. Rather than growth exceeding expectations, we believe it is likely we will hear a more somber tone when management teams address investors.
Stock market valuations have decreased significantly since the beginning of the year. However, when we think about Price to Earnings (P/E) ratios as a way to value stocks, it is important to remember that the “E” drives the “P.” A lower growth rate may already be factored into most expectations, but we believe the potential for further downside risk remains.
Earnings reports are not the only important headlines over the next several weeks. We will learn a lot about the state of the US economy with the release of retail sales, CPI, US GDP, and more. While these data points will serve to shape our views, RiverFront’s disciplined investment process will determine portfolio actions. Our strategies remain underweight equities because we believe it is a prudent course to navigate through periods of volatility and uncertainty.