Economic and Summer Grilling Fundamentals

In our family, as for many others, summer is grilling season. On a burger, I prefer the classic approach: ketchup, mustard, and pickles. Sometimes, though, we experiment—spicy southwest style and BBQ with grilled onions are two standouts this season. But regardless of the toppings, the meat is really the driver of the perfect burger. A solid base makes or breaks it. That’s why I like to buy beef from a local vendor.

This year has brought relatively calm markets compared to last year. But is that calm the “toppings” (which can easily change) or the “beef” (a solid base)?

Well, it’s true that data continues to surprise to the upside. Inflation continues to decline, consumer spending remains strong, corporate earnings are better than feared, and the S&P 500 Index is up around 16% year to date. Recessionary fears seem to be pushed to the backburner.

However, when we look at the meat of the economy, we believe there are some fundamental risks to slower growth going forward. Caution remains warranted despite the calmer start.

Corporate earnings

A slowing economy and lower inflation have brought earnings growth to a halt for S&P 500 Index constituent companies as a whole. Over the past 12 months, we’ve seen corporate earnings stagnate, even as second-quarter earnings have improved slightly on better profit margins.

Let’s dig into some details. Expectations heading into the second quarter earnings season were low. Tech earnings were able to meet the high bar as they came into reporting season. This is surprising because they already had high expectations which helped them to hold up in terms of performance. As of August 15, more than 90% of companies in the S&P 500 Index’s tech sector beat estimates.

For the third and fourth quarter earnings season, expectations are more optimistic, as analysts expect profits to climb nine percent in the fourth quarter. We believe these expectations are overly optimistic. Higher rates and tighter lending standards may continue to slow production. The chart below illustrates possible profit pressure ahead. Firms may struggle to pass these higher labor costs on to customers. At the same time, firms reporting higher selling prices have declined to January 2021 levels showing that they cannot continue to pass higher prices on to customers. Competition for employees should keep wage inflation higher for longer at the expense of profit margins and shareholders.

Concentration in returns

While the S&P 500 Index had a stellar first half of the year, the concentration in returns comes from just a handful of companies particularly focused in the technology sector. In fact, the top seven stocks have contributed to over two-thirds of the return of the index. Much of the trend has been attributed to the artificial intelligence phenomenon. As an example, it took only two months for ChatGPT to gain 100 million users, whereas it took Instagram 30 months and Uber 70 months to reach the same 100 million.

So, while the growth has been good for investors this year, we question how long this trend can persist. We believe in utilizing a balanced approach between both growth and value. This paid off last year when we saw the Russell 1000 Growth Index down almost 30% whereas the equivalent value index was down less than 8%. In fact, there are zero S&P 500 Index stocks that have been up every month over the past twelve months.

Consumer spending

Consumer spending seems to remain strong as retail sales rose for the fourth straight month in July. Consumer spending power is coming from wage growth and excess savings, and we also have to consider continued low unemployment. However, consumer borrowing has increased just as interest rates and consumer default rates are also on the rise. According to research done by Piper Sandler, an estimated $60 to $80 billion in student loan payments resume in the coming months, with 88 percent of borrowers stating that payments will cause financial distress and a majority of respondents indicating they may need to consider secondary sources of income to make the payments. In fact, in Target’s earnings report this week, they indicated that they expected a headwind from the resumption of student loan payments.

Caution at the grill

As rosy as this year has been, we continue to believe the risk of recession remains elevated, and the economy will slow as the year progresses. The impacts of stimulus that have boosted growth over the past couple of quarters will wane.

Within portfolios, we continue to remain conservative and focus on higher quality both in equities and fixed income. We also stress the importance of rebalancing. On behalf of our clients, we have rebalanced as portfolios become equity heavy to their long-term targets and take profits in sectors and managers who have benefitted.

We also recommend reaffirming time horizons. While the short term may bring volatility that hasn’t been seen this year, longer term averages for both stocks and bonds are still good.

All told, this year certainly has been a relief compared to 2022, but when we look hard at the fundamentals—the base on which various “toppings” rest—we see that investors standing at the grill should remain cautious in the short term.