Charles Dickens’ classic novel Great Expectations starts with the main character, a young child named Pip, walking in a graveyard…and getting accosted by an escaped prisoner. Pretty dark stuff. From the start, readers’ expectations for the future are grim.
As with financial markets, expectations matter. What Pip expects shapes his response to what occurs. Let’s use this beginning as an analogy for the start of this quarter’s earnings season. (Note: I won’t give away the ending for those who haven’t read the novel, but suffice it to say it’s not what you’d expect at the outset.)
Grim income expectations had many companies whistling past the graveyard with pressure expected in terms of their ability to pass on price increases, deal with higher costs and, in many cases, grapple with declining unit sales. Although earnings did shrink on average versus a year ago, they actually came in better than expected. The outlook for future earnings growth also improved from what people had expected.
Market reactions & outlook
The market reaction to that better-than-feared profit picture for the quarter has been reasonably good stock appreciation. In addition, the cautious outlook for the future has also tempered, with earnings expectations on average higher for the future than what we would have forecast prior to this result.
This does not necessarily mean everything is great. In our view, there’s more earnings pressure on the horizon. Still, it’s fair to say that earnings downside, or the potential worst-case outcomes, are not as bad as we would have expected before this quarter.
The next chart shows some examples of why we believe the profit picture will continue to be under pressure. Unit sales—or the number of things that companies are selling—have been declining. Price increases have been the only way that companies have been maintaining margins on average in the face of higher costs for raw materials, labor and borrowing. Those price increases are, in most cases, not able to be passed on to the consumer without further loss of unit growth.
At bottom right, the chart shows that Nominal Corporate Revenue growth has been flat. Nominal growth is unit growth plus price changes. Real Corporate Revenue growth (or just sales without any price increases), has been declining and is back to the average trend that was in place prior to the impact of COVID stimulus.
Our base case isn’t overly grim
That last point, back to trend line growth, is important. The decline in profits is off a very elevated level, with the economy discombobulated from a large amount of stimulus and supply chain issues. This may create the feeling or even expectation of a deep recession. This is not our base case.
In fact, other than what we would consider an optimistic market view of earnings over the next few quarters, some of the slowdown in the economy may already be occurring. This leads us to continue to position our equity portfolios for that adjustment to expectations, just as the readers of Great Expectations must adjust to Pip’s situation and view of the future until the two start to align. If those expectations and reality do align, we would be looking for a change in strategy and a potential rebalancing of portfolios.