The risk to earnings

And we’re back.

The column has been away for two weeks, and I have been off work for five. I did not have a single professional thought in that span — my longest break in decades — but can report that my wife and children turn out to be quite nice people.

While I was away, the markets again retraced the same macro-narrative that it has followed, in one direction or another, since inflation began to rev up in the spring of last year. To wit: the market changes its collective view of future Federal Reserve policy, and bond yields and risk asset prices shift accordingly.

The big turning point this time round was on August 16. That was the day the 17 per cent bull run in stocks, which had started two months earlier and took back more than half of the S&P 500’s 2022 losses, peaked and turned over. Since that day, the market has chugged back towards its June lows. The US central bank is the culprit. As Ethan pointed out at the time, that was the week that Fed presidents fanned out across the country to say that, no, the Fed was not going to back off any time soon. The message played on repeat right up through chair Jay Powell’s Jackson Hole speech.

As expectations for the Fed’s peak rate rise have risen — they are just a hair under 4 per cent for March of next year, 30 basis points higher than on the 16th — stocks have fallen, as the script demands. Treasury bond yields, junk bond spreads, currencies, industrial metals, oil and value/growth relative performance are all dancing to the same tune.

It is discouraging, from a financial journalist’s point of view, that the narrative that dominates the market is so straightforward. Crude AI software could crank out perfectly good analysis of what’s going on, turning Ethan and I into John Henrys of financial punditry. With that in mind, in the days to come we’ll try to push beyond the standard Fed pivot narrative — starting today with a look at corporate earnings.

Email us: robert.armstrong@ft.com and ethan.wu@ft.com. 

Can earnings continue to save the day?

One likely reason that the market has not performed even worse in the face of inflation and the threat of a slowdown is that earnings have held up well. According to FactSet, earnings of S&P 500 constituent companies grew earnings by over 6 per cent year-on-year in the second quarter, near historical averages, despite a hard comparison to stimulus-crazy 2021. Especially encouragingly, profit margins in the quarter remained more than a percentage point above their five-year average, at 12.3 per cent (and the past five years have been pretty good for margins). Costs are rising, but companies have pricing power.

Beneath the decent headline figures, it should be noted, there are quibbles:

• Earnings resilience is being distorted by bumper profits in the energy sector. Strip out that sector, and second-quarter earnings plunge from 6.3 per cent growth to a 4 per cent decline, notes FactSet.

• Cyclical sectors are showing wear. Earnings for financial and consumer discretionary groups fell 23 and 18 per cent, respectively, in the second quarter.

• Revenue figures are being puffed up by inflation. Ex-energy, real second-quarter sales growth for the S&P came in under 1 per cent, according to Bank of America.

That said, earnings do not appear set to fall off a cliff. Both yesterday’s ISM services activity survey and real time economic measures suggest that the economic backdrop remains relatively strong in the third quarter. We are not sliding into recession right now. The question is 2023.

Wall Street analysts are still not pricing in anything resembling a recession next year. Here is FactSet’s chart of the evolution of EPS estimates for this year and next for the S&P 500. Both have come down by a few percentage points, but 2023 earnings are expected to come in solidly ahead of ‘22:

The simplest argument for disappointing earnings next year has been written right to death, here and elsewhere: the Fed tightens us into a recession, either because that is what they have to do to control inflation, or by mistake. Somewhat less discussed is the threat from a contraction in government deficit spending.

Remember that useful bit of national income accounting, the Kalecki Profit Equation:

Profits = Investment – household savings – foreign savings – government savings + dividends

Without going into the derivation of the equation, the dumb point here is that like all accounting identities, this one has to balance. If profits are to rise, investment or dividends must rise, or savings of some kind must fall. And the account that has historically balanced increases in profit is government savings. That is, as government deficits rise, corporate profits tend to do the same, and conversely. It doesn’t have to be this way, but it usually is. As Jeremy Grantham put is in his latest piece predicting financial Ragnarök:

Government deficits and corporate profits are on opposite sides of a ledger that sums to zero. Historically, there’s been a powerful statistical relationship between changes in the government deficit and subsequent changes in profit margins: major increases in deficits have led to rising profit margins over the next few years, and major decreases in deficits have led to falling profit margins. We have just seen one of the biggest decreases in the government deficit in history. It is very likely to be matched by a subsequent drop in profits.

Like a lot of what Grantham writes, this smells a bit of brimstone, but there is logic here. When the government is borrowing and spending heavily, it makes sense that those dollars would show up, directly or indirectly, as corporate profits. The government sent out stimulus cheques to consumers, consumers spent, companies made money. Or to put it another way: yes, companies have pricing power, but that is only because the government has stuffed their customers’ pockets with money.

Is the era of fiscal largesse really over? For months, everyone assumed that Democrats would get creamed in the November midterm elections, leaving the US with a divided government — a sure way to slow spending.

But a Joe Biden renaissance has dawned. Lower gas prices, legislative wins and an unpopular Supreme Court ruling on abortion have helped Dems build a modest but growing lead in the national polls. If Democrats hold on to Congress — election-data gurus give them one in four odds — it would mean two more years with the fiscal spigot open.

Three-in-four times that doesn’t happen, though. And barring additional spending, US fiscal policy looks set to be contractionary. Brookings estimates fiscal policy, chiefly the unwinding effects of coronavirus pandemic stimulus, knocked 4.5 percentage points off real GDP growth in the second quarter, and will continue dragging on growth for years. Biden’s most recent legislation is no different. The Inflation Reduction Act looks to be, on net, mildly contractionary, dinging earnings next year while slashing the deficit:

Isaac Boltansky, BTIG’s policy analyst, sums up the risk: “During times of divided government we see belt tightening — because it is impossible to legislate . . . what scares me is, if we do see a downturn, we will not see the same level of fiscal support.” (Armstrong & Wu)

One good read

In case you missed it while you were out at the beach last week, Unhedged’s now notorious friend Stuart Kirk, has written a smart piece about ESG’s conceptual problems.

Kirk makes a distinction between two types of ESG investor. “Input” ESG investors focus on how ESG risks — climate, bad governance, whatever — affect returns. “Output” ESG investors focus on how their investments make the world a better place.

Kirk argues that the two are so different that “ESG should be split in two”. We’d go further: ESG input investing is just plain old investing, that is, the pursuit of the best possible risk-adjusted returns. It does not exist independently, except as a general view that a certain set of risks are systematically underpriced by markets. It could lose that distinction, too, should market prices change enough (ESG is not a “factor”, like value or size, enduring sources of superior long-term performance where investors reap higher returns in return for taking certain kinds of risk).

As for output focused ESG investing, Kirk says “the industry must be honest about the trade-off between returns and ‘doing good’”. Again we’d go further. The only way ESG-output investors can change the world is by accepting below-market returns. That’s the only way their capital will fund world-improving projects that would not otherwise be funded by regular investors.