Q2 Review: All About E(arnings)

Investment Commentary and Economic Outlook: It’s about Earnings

After posting new closing highs in late 2021 and the first trading day of 2022, equities fell sharply during the first half of 2022 with the S&P 500® dropping nearly 21% and the tech-heavy NASDAQ composite falling 29%.  This was the worst first half stock market performance in over 50 years.  Concerns surrounding higher inflation, which began accelerating in mid-2021, lower economic growth and corporate Earnings have weighed heavily on markets; worries which have been exacerbated by an unambiguously hawkish posture at the Federal Reserve.

As of this writing, the S&P 500® Index is trading at 15.8 times our CY 2023 earnings forecast, slightly below the Index’s 10-year P/E average of 16.6 times. The market’s current valuation reflects an earnings yield of 6.3% or 330 basis points above the 10-year treasury as of June 30th.  This is a dramatic change in valuation relative to December when the market was trading at 21.9 times the CY 2022 forecast and the earnings yield premium above treasuries was 300 basis points.  In other words, we think at this valuation level the market has already adjusted to current and anticipated increases in interest rates and stocks are very attractive over a 12–24-month time horizon.

Our strategy, at this juncture, is to be adding to positions in those singular companies likely to sustain solid sales, market share and earnings growth regardless of underlying economic conditions.  At current levels, the technology sector in particular, appears to have priced in potential downside economic risk.  From a portfolio management standpoint, we believe our job is to distinguish signal from noise; for reasons set forth below, there is a lot of noise in the market today, a condition well-suited for Roanoke’s style of research-driven active management.

In this note, we outline both the sources of puzzlement and where our convictions are strongest. As always, we welcome the opportunity to discuss, clarify or elaborate upon our current thinking.

Current Economic and Company Indicators Reflect COVID-19 Related Distortion.

Reflecting upon the past 24 months, we are reminded, first and foremost, of the global dislocation and scale of suffering wrought by the COVID-19 virus with over 550 million known cases and 6.6 million deaths.  The pandemic precipitated the most momentous coordinated global response to a crisis since the Second World War.

Aggregate fiscal stimulus worldwide exceeded $10 trillion or roughly 12% of global GDP. At the same time, the United States and other developed economies embraced accommodative monetary policies featuring near-zero interest rates and, remarkably, at its peak level in 2020, $18 trillion in negative yielding sovereign debt.

The positive impact of these measures is undeniable. Rather than a long, drawn-out period of economic malaise, most economies enjoyed a V-shaped recovery.  Government transfer payments and rock-bottom rates fueled a rapid rebound that commenced in the Q3 of 2020 and was sufficiently powerful to limit the economic damage globally to less than 3% of GDP, setting the stage for blockbuster gains in 2021, a year in which global GDP rose over 10%.

Growth patterns were profoundly impacted by lockdowns and related shifts in consumer demand with healthcare, consumer discretionary and staples, information technology and communication services firms benefiting while many service companies especially in the travel and restaurant sectors suffered mightily.

Some of the standout beneficiaries:

-       Apple:  Company was forced to close all 500 stores in the Q2 of 2020 but still managed to generate $59 billion in sales.

-       Amazon: Sales accelerated from 16-19% growth to over 40% for 4 straight quarters.

-       Best Buy: Comparable-store sales rose 37% in the Q1 of 2022.

-       Nvidia: Stay-at-home kids of all ages increased gameplay hours on Nvidia platforms by 50%.

-       ZOOM: Perfectly positioned for lockdown-driven demand, revenues grew 370% in the Q2 of 2021.

Shifting demand driven by work from home regimens contributed to distortions in normal consumer expenditure patterns and produced unexpected supply chain dislocation while the outbreak of war in Europe produced an additional shock to the food and energy complex.

Recent company results reflect this dislocation that has caught even the best managed companies off guard.  Target, for example, one of the best managed retailers in America, recently issued disappointing guidance related to gross margin pressure tied to bloated inventory levels - sales of durable goods were reverting to more normal levels and inventory levels were too high, up over 40% year-over-year.

We expect that revenue and earnings comparisons with 2021 figures will continue to cause consternation among investors who mistakenly believe that the growth prospects for all companies have somehow permanently diminished.  And so, we expect volatility to remain a market characteristic through the end of the year.

What We’re Watching.

Inflation

Inflation expectations and, relatedly, the degree to which the Federal Reserve raises short-term rates to cool economic growth, will importantly impact market direction in the near-term.

Rising inflation expectations affect consumer behavior in three ways. First, higher prices reduce real interest rates, diminishing consumers’ incentive to save. At the same time, expectations of higher prices cause consumers to accelerate spending so they can avoid future increases, driving up demand and potentially causing prices to spiral even higher.  Lastly, higher inflation erodes purchasing power.

Ultimately, market direction will rest on the degree to which inflation expectations are contained. In this regard, we believe there is a significant probability that the Fed will overshoot its objective with the Fed Funds rate having increased six-fold since March, albeit from an extraordinarily low base.  Just as the combination of fiscal stimulus and easy monetary policy powered growth, restrictive fiscal measures along with the reversal of quantitative easing - the Fed intends to allow up to $47.5 billion in maturing bonds to roll off its balance sheet each month beginning in June - along with higher interest rates, have already begun to restrict economic activity and ought to cool inflation. 

Economic Activity

Commodities such as lumber and copper are down substantially from their recent highs, manufacturing activity slowed more than expected in June with the ISM showing factory employment contracting for the second straight month.  The money supply, as measured by M2, after having grown over 30% through the course of the pandemic, is actually down since the beginning of the year while consumer spending is trending lower. 

Employment, Wage Growth, and the State of the Consumer

One source of puzzlement among all the economic and company indicators we track is the disconnect between consumer sentiment and the job market. Unemployment is at a record low and the June jobs report showed stronger-than-expected hiring with over 372,000 new jobs created.  Wage growth remains strong, though not quite keeping up with inflation.  Labor force participation does remain below pre-pandemic peak levels, a potential source of slack in the market should wage cost pressures continue to build.

Yet, consumer sentiment is awful with the widely watched University of Michigan’s Survey of Consumer Sentiment touching an all-time low of 50.0; nearly 80% of those surveyed expect bad times in the year ahead.  Consumers are struggling with very visible changes in their cost of living - food and gasoline. Although pump prices have recently retreated a bit from $5.00 nationwide - an all-time high - the cost of transportation is an everyday, visceral reminder that inflation is here and it’s impactful.

To cope, consumers have taken on more credit card debt - up 7% after a period of zero growth while drawing down savings, which now stands at 5.4% of income, down from 8.5% at the beginning of the year.

Insofar as consumer spending represents 67% of GDP, the resilience of the American consumer will dictate the direction of the economy in both the near- and long-term. Our view is that as supply disruptions dissipate and energy prices fall, as they are starting to fall, the mood of the consumer will improve, supporting normalized spending gains. 

While we’re constructive on equities over the 12–24-month time frame, we believe that near-term risks are elevated.  While rates have come down since their recent peak, the solid June employment report makes it more likely that the Fed will again raise its target rate by 75-basis points at the July FOMC meeting.  The market currently anticipates another 50-basis point hike at the September meeting which would bring the short-term rate target to 3.0%.

Pundits are divided as to whether these aggressive Fed actions will push the economy toward recession following the 1.6% contraction in Q1 GDP. The headwinds of falling consumer confidence, rising interest rates and reduced money supply all have the potential to interrupt growth in the near-term.  The yield curve is slightly inverted currently, another signal of potential economic contraction.

Currently, analysts are forecasting an acceleration in 2H earnings growth for the S&P 500® Index to 10-11%, up from 5% expected in the Q2.  Given the significant contribution of the energy sector to S&P 500® earnings in the 1H, a growth trend unlikely to persist through the end of 2022 as comparisons get tougher, we see downside risk to market forecasts.

Concluding Thoughts

We believe in the power of the American system to support innovation leading to improved efficiency, higher labor productivity and ultimately sustained economic growth in the long-run and get excited when we’re able to add long-term winners to your portfolio during times of heightened trepidation.  While there exist sources of uncertainty and a number of unambiguous headwinds in the near-term outlook, we are reminded that what is known is priced in, investors with short-term time horizons are sellers and that creates opportunity for those seeking to grow wealth over the long-term.

Thank you for the confidence you place in us.