It is easy to get lost in the market noise. Pundits write endless articles about almost every aspect of the economy and markets, trying to turn over any loose stones. We have even written quite a bit recently about the swirling winds of inflation, the Fed, interest rates, supply chains, and geopolitical conflict. But in the end, it really is quite simple: corporate earnings are the engine that drives markets. After all, the price of a stock is simply the summation of all its estimated future cash flows. Further, the market itself is the summation of all those individual streams of company cash flows. So, when we talk about inflation, interest rates, and everything else, what we are really asking is what this will do to the present value of all those future cash flows.
We wrote about the earnings picture about 8 months ago when the market was coming off a 40% year over year growth rate, and we noted that earnings growth was due to decelerate, as it has. With all the macro headwinds that have boiled over since we shared that piece, how is earnings growth looking this quarter? The expectation for growth for the first quarter is just over 4% – remarkable considering inflation is running at 40-year highs near 8.5%. Some of this resiliency is due to the rise in profits for energy and commodity companies, but so far non-commodity companies have shielded themselves from rising input costs, sticky supply chains, and higher interest rates.
The key question to ask this earnings season is whether companies can continue to maintain pricing power, protect margins, and grow their earnings. Chart 1 below shows current analyst expectations for earnings to accelerate in the back half of the year, from 4% growth this quarter to 8% growth by the 4th quarter. This may prove overly optimistic in light of the many headwinds companies face, and our expectation is that these numbers are likely to be revised lower. However, revisions should not be any surprise as part of the market weakness we have seen year to date is the market sniffing this out. Analyst earnings estimates are notoriously sticky and slow to adjust – market prices typically move well ahead of the actual changes in earnings estimates.
It remains to be seen whether these revisions will be materially worse than built-in expectations. It is hard to turn on a financial TV channel and not hear someone throwing around the “R” word: Recession. Earnings take their largest cuts in recessions, as shown in Chart 2. We are not here to say that a recession is not possible – recessions are always possible. But there are plenty of countervailing forces arguing against recession as well. On Wednesday 4/13, the Delta Airlines CEO noted that bookings are at record levels despite the increase in ticket prices – there is still a lot of pent-up travel demand. JPMorgan’s recently reported results showed that “consumer and business balance sheets as well as consumer spending remain at healthy levels,” but also acknowledged the economic challenges ahead. Lastly, there are early signs that inflation may be coming off the boil. From recent peak prices, oil is down 25%, steel is down 16%, aluminum is down 20%, and wheat is down 15%.
The economy is not out of the woods, as we will need to watch supply chains closely in light of increasing Covid lockdowns in China, the Russian war in Ukraine, and the pace of upcoming Fed rate hikes. This upcoming earnings season will be critical as companies discuss what they are seeing on the economic landscape and offer their forward guidance for profits. As we often do when fears are high, we would like to emphasize the long-term resiliency of corporate profits, and by extension, market prices. In 1968, the year before the great inflation of the 1970s began, S&P 500 total earnings were $5.72 per share. Today, 44 years later, the estimate for this year is $227 – an almost 40x increase equating to about an 8.5% growth rate per year. This was through seven recessions, multiple wars and conflicts, and countless fear-driven headlines. Even when the short term seems choppy, we would be hard-pressed to bet against the long term drive of companies to increase their bottom line.