The deterioration in the economy has been clear in recent months, but the equity markets have confounded many investors. Stocks are just 10.6% off their highs and have shown some remarkable resilience, particularly in the last few weeks. There’s a great tug-of-war going on underneath what appears like a potentially frightening macro picture.
A closer look shows that what we’ve primarily seen is deterioration in the macro outlook and not so much in specific corporate outlooks. Despite the persistently weak economy, earnings aren’t falling out of bed. Without a sharp decline in earnings there is unlikely to be a sharp decline in the equity markets (outside of some exogenous event such as a sovereign default).
The most distinct characteristic I can recall from the the 2007/2008 market downturn was the persistent deterioration in earnings. Like dominoes we saw the various industries go down one by one: housing, then banks, then consumer discretionary and on down the line. While the macro picture has deteriorated recently we haven’t seen the same sort of deterioration in earnings that we saw in 2007 and 2008.
In a recent strategy note JP Morgan elaborated on the divergence between the macro outlook and the earnings outlook:
“What matters for equities is earnings and not GDP growth. US GDP growth projections are being cut, but earnings projections have been little affected so far. Investors and analysts are hoping that, to the extent the soft patch in US GDP growth lasts for only a few quarters and does not spillover to the rest of the world, US companies will be able to protect their revenues and profits. Indeed, this is what happened during 2Q, when US companies were able to deliver strong top line and EPS growth even as US GDP grew at only a 1% pace.
It is a prolonged soft patch that poses the greater threat for corporate earnings and equity markets as it raises the specter of deflation and profit margin contraction. Why is deflation bad for corporate profitability? When nominal interest rates are bounded at zero, a fall in expected inflation causes a rise in real interest rates and the cost of capital, hurting corporate profitability. In addition, nominal wage rigidities mean that deflation reduces output prices by more than input prices putting pressure on corporate profitability. Indeed, the Japanese experience of the 1990s provides an example of the erosion in corporate margins under a deflationary environment.”
BlackRock’s Bob Doll also highlighted this in his latest strategy note:
“To us, one of the more interesting features of the current economic and market landscape has been the continued resilience of the corporate sector in the midst of weak economic data. The growth in corporate profits and the ongoing decline in corporate credit spreads are forecasting economic strength. In fact, corporate profit margins as a percentage of GDP are near 40-year highs. During a normal economic cycle, such levels would encourage companies to spend more on capital expenditures and/or ramp up hiring plans, but most companies have remained reluctant to reduce their cash levels. We have seen some increases in capital spending, but a lower amount than would normally be expected given current profits, and, of course, private sector hiring has remained anemic. Some of this reluctance to spend can be attributed to uncertainty surrounding potential legislative and regulatory changes coming out of Washington, but we believe that we are at a point where companies will need to either accept slower growth levels or begin to put more of their capital to work.”
The ability of US corporations to maintain their bottom lines in the last two years has been remarkable. But this strength in earnings will not persist without a rebound in revenues. As I recently highlighted analysts have become increasingly optimistic about the rebound in corporate profits, however, the sustainability of a margin based recovery is limited without organic revenue growth. My analysis leads me to believe that the macro outlook will remain weak despite recent signs of strength in some reports. Corporations tend to be reactive to the macro outlook which likely means they will keep their cost controls tight and maintain a defensive posture. At the end of the chain is the analysts, who tend to be reactive to what corporations tell them.
The best way to visualise this is with the following image. The macro economy tends to be the leading factor in corporate decisions. This is why we will often see the business cycle peak at the point of rampant exuberance and mass layoffs at the trough in the cycle. Corporations are not always out in front of the business cycle and in fact are usually reactive to the macro environment. When times are good they spend. When times are really good they spend excessively. The opposite goes for the downside.
Analysts are the ultimate lagging factor in the equation. A close study of analyst’s expectations will reveal very close ties to what corporations actually tell them. This generally comes via the form of press releases (when Apple says they’ll earn $1 next quarter 75% of the analyst estimates are near $1 even though Apple ALWAYS beats), but can also come via the form of direct communication with analysts. Corporations understand that the estimates matter a great deal to their stock price performance so they keep communications tight. A growing economy is the perfect environment for wise executives who literally toy with the analysts by continually under promising and overdelivering.
The macro picture has deteriorated in recent months, but it has not collapsed. This has reduced the margin for error in terms of corporate earnings. Toying with the analysts isn’t as easy as it was 6 months ago. Intel and Cisco’s warnings a few weeks ago were likely previews of what will become a trend in the coming two months. If the macro picture continues to deteriorate (which I think there is a fairly high probability of) we will slowly see a deterioration in corporate earnings and a lagging effect at the analyst level. But with a slowly deteriorating macro picture this won’t unravel overnight. While most investors like to wish that this process would occur immediately (the equity markets suffer from a nasty case of A.D.D.) that just isn’t the case.
The global economy is like a battleship moving through rough sees. Right now, I think we’re at a critical juncture where the ship is turning south through rough seas. Deterioration at the macro level is clear, though we are likely to see it play itself out over the course of several quarters. If the macro environment deteriorates more than I presume the earnings picture will have a snowball effect. And of course, the same can be said of a positive macro surprise (with markets reacting positively). While we’re beginning to see cracks in the earnings foundation we are not seeing a full blown collapse as we saw in 2008. The market has been volatile, but it has remained resilient because we just aren’t seeing the weakness in corporate earnings. Persistent macro weakness and a few more earnings seasons will likely change that as corporations move to adjust expectations heading into a more difficult environment and the analysts subsequently play catch-up.