Coming into the second quarter, many investors were worried that earnings disappointments and 2023 guidance warnings would send the market lower. That did not happen. Approximately 87% of companies in the S&P 500 have reported through May 8th according to Bloomberg. Sales growth has been a decent 4.3%, and earnings have declined 3.6%. While those numbers were mediocre, they were a lot better than feared. Sales were approximately 2.7% above expectations, while earnings surprised materially and ended up being 6.7% above expectations. An imminent recession and earnings collapse is not showing up in earnings or 2023 company projections. The economic environment is tougher, but not yet recessionary. The earnings data includes recessionary conditions in several key industries including housing and semiconductors. In sum, earnings were not great, but they were still good enough to beat lowered expectations and support the S&P 500.
Earnings and the economy hold up until they don’t. When recessions start, earnings fall. The magnitude depends on the excesses during the expansion and the depth of the recession. We still believe a mild recession will start in the second half of the year. Several indicators that have historically been good predictors of recession are indicating a contraction is near. However, we are not convinced that a recession must occur. This time could be different. There are few historical precedents for what happens after a global pandemic. The most recent one started near the end of World War I and may not be comparable. Demographics point to a tighter labor market moving forward. Moreover, service sector economies are inherently less cyclical than manufacturing and agrarian economies that dominated the past. Strong labor markets and an economy dominated by services could mean a recession might be avoided.
We know we are repeating ourselves, but we feel any recession would be extremely mild and earnings would fall less than feared and recover rapidly. The biggest risks to this call are the turmoil in the banking sector, and the possibility that the United States defaults on its debt. While the banking sector’s profitability has been weakened by the inverted yield curve, it does not appear that the losses are so large that they will topple the entire economy. A solvent, but stressed banking sector may help the Federal Reserve bring down inflation. As for the debt ceiling, we think it is unlikely our government will default despite the intense partisanship which makes compromising difficult. A default does not help anyone, and so it is unlikely even if scary headlines and market selloffs occur before a deal is completed.
NPP thinks contained market volatility within a trading range is likely for now, but it is unwise to bet against equities in the long run. We think investors underestimate the resiliency of companies in the S&P 500. Earnings are holding up despite numerous headwinds. As we move through them, investors can look for positive returns even if there is a heightened chance of a pause or pullback in the immediate future.