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Strong Corporate Earnings Reports Support U.S. Equities

August 01, 2022

                The start of 2022 was a major disappointment for the S&P 500 and global equity indices. Higher inflation, rising interest rates and geopolitical uncertainty combined with stretched valuations to precipitate a bear market. At least temporarily, equity markets have found their footing. The initial sources of support included indications inflation is peaking along with a drop in interest rates. Much improved valuations along with the Federal Reserve pivoting to two-sided risks for inflation and the economy contributed too.

                A good part of the recent rally was due to much better than feared earnings. Second quarter earnings reports began to flow mid-July and reached a peak in the last week of the month. Robust sales growth and better than expected profits helped to power markets higher. Approximately 55% of S&P 500 companies reported through the end of July. Sales grew 13.80% while earnings improved 5.98% according to Bloomberg. The energy sector had the strongest revenue and earnings growth which was expected after the rise in energy prices. However, the most important reports came from tech and internet leaders such as Apple, Microsoft, Google, and Amazon. The numbers weren’t great, but they were much better than feared and indicated that their business models can still churn out impressive profits despite economic uncertainty. A host of other companies released reports that beat expectations as well. Sales and earnings came in 2.14% and 4.14%, respectively, above expectations through July 29th according to Bloomberg. It should be noted that companies report in nominal dollars and most large ones were able to defend earnings. Their margins fell a little but held up well in aggregate.

                This isn’t to imply that the entire rally was due to earnings. The Federal Reserve and Chair Powell indicated that potential weakness is now becoming more of a concern and there are two-sided risks to the economy after raising the Federal Funds rate seventy-five basis points on Wednesday, July 27th. The Fed is now data-dependent, but NPP thinks that goes without saying. If inflation falls, there will not be a need to raise interest rates. It will almost assuredly decrease, but the issue is where will it stabilize. Inflation has already started to come down by a couple measures and forward indicators point to moderating inflation. However, a reduction in inflation is not the only requirement for the Federal Reserve to end this raising cycle. Inflation must come down to 3% relatively quickly and then hopefully move lower. Inflation reports will be of utmost importance until the next Federal Reserve meeting in September.

                The economy has clearly slowed, but whether we are in a recession is debatable. Real GDP has declined for two consecutive quarters. This has historically coincided with a recession, but in the past, two consecutive quarters of negative GDP growth were accompanied by job losses. That did not happen in the first half of 2022. The labor market moved from extremely tight to less tight while people that were laid off were able to quickly find new positions. If we do go into recession, or are in one right now, it will likely be brief all else being equal. There are potential risks in the housing market and consumers are stretched due to inflation. However, jobs are plentiful, the banking sector appears well-capitalized, and most corporations are in good financial shape. In sum, the risks appear manageable.

                 Earnings are likely to hold up relatively well in a mild recession scenario. 2021 earnings were $193 according to Bloomberg, while 2022 estimates are around $220.  Assuming a minor recession, earnings are likely to come in below current estimates. Sell-side analysts estimate earnings of about $116 for the second half of 2022, while earnings for the first half will be approximately $104. Earnings would have to plunge twenty-five percent below current estimates in the second half of the year for 2022 earnings to match last year’s number. That is possible but seems unlikely given that current guidance incorporates what happened in much of July.

                The economy is unsettled, and we are paying the price for easy monetary and fiscal policy here and globally. Stressed supply chains, shifting consumer spending habits, and the Ukraine invasion have also caused problems for the economy, consumers, and many companies. Somehow large companies continue to churn out record profits despite this difficult backdrop. This should not be surprising. Higher inflation has so far flowed through to the bottom line even if it has helped certain companies while hurting others. Profits are still at risk, but some of that has already been reflected in asset prices.

                NPP thinks the S&P 500 bottomed on June 16th. There are a host of risks to that call, including a tight labor market and inflation. A modest recession has probably been discounted, but we think it will require falling inflation in the second half of the year for equity markets to move materially higher. We don’t think the upside is capped here, but economic data will need to cooperate once peak earnings season ends. While NPP thinks the market will consolidate in the short-term, we do not believe a new low is likely for the S&P 500 in 2022. There are clearly better values for long-term equity investors than when the year started. We think earnings must fall materially for the bear market to worsen. We live in uncertain times and the Federal Reserve is data dependent. NPP thinks the most likely path is a sideways market until a post-COVID trend asserts itself.