BMO Family Office
“One of our worst traits in journalism is that when we have a narrative in our minds, we often plug in anecdotes that confirm it. Thus, we managed to portray President Gerald Ford, a first-rate athlete, as a klutz.”
– Nicholas Kristof
A narrative on the U.S. economy is starting to take shape. It is one of stickier inflation, Fed tightening, slowing growth, and an equity market presumably priced for a type of perfection that has all but faded from view. The visual of stockpiled cargo containers reinforces the reality that supply chains are getting worse, not better, and producer prices increasing at almost 1% per month implies continued inflation “in the pipeline” (Exhibit #1). As with most narratives, the more it takes hold, the more it becomes the lens through which other developments are interpreted. We have been messaging an expectation of a balanced market for several months now, and equities have seen more ebb than flow of late. It is important to note, however, that just because a narrative is forming doesn’t mean it has staying power.
High levels of inflation are indeed likely to persist for a few more quarters, but what is more important is that inflation begins to show signs of peaking – which we expect to materialize in early 2022. This should give the Fed breathing room to stay reasonably patient on expectations for future interest rate increases. We will get updated readings on the Fed’s leanings at both the November and December meetings, although only December will have a formal updated set of projections. Projections from prior quarters pulled forward the expected timeline for future interest rate increases, but not aggressively so. In general, it is important to note that the equity market has historically performed well in the early and even middle phases of Fed tightening cycles.
That positive equity market performance – despite interest rate headwinds – has usually come from continued economic and earnings growth. While today’s supply chain issues could lower earnings estimates by a few percentage points, if this effect is limited to 2022 then the impact on equity valuations should be quite minor. Early indications from Q3 earnings season indicate the impact, in aggregate, may not be large even if certain individual companies experience bigger hits (see Q3 Earnings Preview special section). As 2022 gradually unties these supply chain knots, the fundamentals of a healthy job market and favorable wage growth should support consumer spending. Additionally, expectations for business spending continue to look robust (Exhibit #2).
It is also important to recognize that slowing growth caused by supply constraints is much better than having a period of demand softness. At a macro level, U.S. GDP is now above pre-pandemic levels. The total number of people employed compared to the pre-pandemic period, however, is still running at a deficit of five million. It’s a staggering number that pushes total employment levels all the way back to 2017. But the current GDP-to-total employment relationship speaks to earnings and profit margins remaining elevated.
While we do not dismiss a more malignant market narrative, we do believe it lacks staying power. For one, downside follow-through in equity markets is typically preceded by high-yield debt spreads increasing markedly (that spread being the interest rate on junk bonds in excess of that on high-quality bonds). While no indicator is perfect, the current environment shows nothing of the sort (Exhibit #3). Additionally, it is unclear that the Fed will become increasingly hawkish or that earnings will surprise to the downside in coming quarters. Growth is slowing; that is well established. It is not, however, grinding to a halt as images of anchored cargo ships might lead one to believe.
In recognition of the ongoing uncertainty, however, we have recently made a shift in tactical positioning to bring emerging market equities to neutral (from overweight) in favor of an allocation to U.S. REITs (“Real Estate Investment Trusts”). Historically, REITs have performed well in periods of above average inflation, and several large REIT industries such as the Industrial, Infrastructure, Data Center, and Residential areas have considerable pricing power and growth prospects. At the margin, this change is risk-reducing for portfolios. While emerging market risks are similar to those in the U.S. – global growth trends, inflation, higher interest rates, and a Chinese growth slowdown – emerging markets are likely to have greater sensitivity in downside scenarios.
As for the final element of the current market narrative – extreme equity valuations – our models point to modest, not extreme, overvaluation. It is worth noting that these models are sensitive to the level and path of longer-term interest rates, and we have already considered increases in coming years. Interest rates would have to rise sharply from their current range before equity valuation levels would warrant a position change. In sum, it’s not that the current market narrative has no possibility of becoming an economic reality in 2021; it’s just premature to assume those pieces are all going to fall into place.
Q3 2021 Earnings Preview: Supply chain kink in the outlook
With the Q3 earnings season kicking off, investors will be paying close attention to how companies are navigating the myriad of supply chain issues and other cost pressures. While investor expectations are lower than they were three months ago, stocks may struggle to move higher in the near term as investors readjust to less extreme earnings relative to previous quarters.
For Q3, S&P 500 earnings per share are expected to grow 27% (per Refinitiv) – a far cry from the 88% increase last quarter. This quarter, we have tougher year-over-year comparisons combined with unrelenting cost pressures. Of the roughly two dozen S&P 500 companies that have reported at the time of this writing, 76% have beaten on earnings, which is favorable relative to the historical average of ~70%, but well below the beat rate for the last few quarters.
On recent earnings calls, company managements have been almost universally positive regarding the demand environment. That enthusiasm, however, has been offset by cautious commentary around supply chain challenges and other cost pressures. Some sectors, such as Consumer Discretionary, have seen estimates decline recently as they are more susceptible to rising energy and raw material costs, component shortages, clogged logistics networks, and wage inflation. On the other hand, sectors such as Energy and Materials have seen estimates increase as they benefit from rising commodity prices. Additionally, some areas such as Semiconductors have been able to pass along higher costs to their customers, but a higher level of earnings misses are possible for companies with less pricing power.
Currently, Wall Street analysts forecast that cost pressures will cause S&P 500 net profit margins to decline from a record 13.1% in the last quarter to around 12.1% in the third quarter, and a bit below that by yearend (Exhibit #4). For 2022, analysts are now calling for 10% earnings growth, but that is down from 12% three months ago. Such declines are typical as the new year approaches, but acceleration to the downside in these estimates – should it occur – might indicate more lasting challenges.
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