Fall Leaves and Profits Squeezed?

My favorite season of the year is fall. I enjoy the crisp air, the beautiful fall colors, and everything pumpkin spiced. Just as fall foliage signifies a new season, company earnings reports—announced quarterly during “earnings season”—point to changes in the markets and the economy. Third-quarter earnings are just beginning, and these reports will give insight into the economy and recession indicators.

This year’s market sell-off is reflective of a difficult earnings picture. Rising input costs, demand erosion, and geopolitical risks have all contributed to the uncertainty. Now, heading into this earnings season, investors anticipate squeezed profits given rising interest rates, high inflation, and slowing economic growth.

We’re still in the first half of earnings season (see the chart below for when S&P 500 constituents report). So far, company reports have been better than feared as evidenced by the stock-market rally on Monday and into Tuesday, driven primarily by the financial sector. An important caveat is that earnings estimates have been revised lower all year, due to slower growth and increased uncertainty, making them easier to beat now. 

Most of the banks exceeded expectations for earnings and revenue and detailed that consumers continue to spend and deposits are still healthy. Citigroup, Bank of America, and JP Morgan all reported rising revenues. In the minority are companies like Disney, which reported demand destruction as a result of higher prices.

Why we pay attention to earnings

Company earnings help us to understand where we fall in the economic cycle. One model we look at to understand the cycle is the H.O.P.E. model, which stands for Housing, New Orders, Profits, and Employment. As rates rise, it takes several quarters to impact each of these sectors. Our 4th Quarter Outlook talks more in depth about this model. Following is a brief overview:

• Housing - The earliest indicators to slow include housing indicators such as the National Association of Home Builders Index and new building permits.
• New Orders – Next to slow are new orders through manufacturing sales and inventory levels. Both the Housing and Orders indicators have already shown signs of slowing this year as higher interest rates have deterred buyers and companies now carry higher inventories.
• Profits - That brings us now to profits. Earnings always fall in a recession. Earnings for the first half of the year were better than expected, but third-quarter reports will provide further insight into this economic cycle. We not only look at reported earnings but also pay close attention to commentary from management to analyze company and consumer health. If and when we see slowing profits, we will turn attention to employment data.
• Employment - Employment indicators are the most lagging part of the economy with payrolls, personal income and finally core CPI inflecting. However, it is important to remember that the stock market is forward looking by about nine to twelve months and CPI tends to be a lagging indicator.

Portfolio implications

If we wait for all the data to turn positive, it is too late. What we can do is position portfolios to ride through the volatility that we’re experiencing. In client portfolios, we have positioned more defensively favoring value over growth, domestic over international, and large cap over small cap.

On the bond side, we have increased quality by reducing high yield and increasing investment grade and favoring government bonds over corporate.

By the time the leaves fall from the trees—and this earnings season wraps up—we may have a better sense of where we are headed next.