by Joseph V. Amato, President and Chief Investment Officer—Equities, Neuberger Berman
As it’s Halloween, you may be settling down to a scary movie this evening. For those of us deeply engaged in financial markets, it’s been “Nightmare on Wall Street” for most of this year. Is this movie finally coming to an end?
The July and August equity market rally was a premature victory celebration: It turned out the inflation monster was still ominously stirring in the background. The past two weeks have felt eerily similar, with investors again pricing for easing inflation and rates conditions. This time, they are taking their cue from deteriorating economic data and, especially last week, mixed third-quarter earnings results from some high-profile U.S. companies.
Look more closely at recent earnings results, however, and they appear to reveal a still resilient U.S. economy. And that presents a real conundrum for the U.S. Federal Reserve. Should the economy remain resistant to tightening financial conditions, what might policymakers do? Keep pushing until the economy breaks, or pivot?
Nominal Versus Real
One of the biggest current challenges for both the Fed and equity investors is the extreme divergence between nominal and real economic growth, which is feeding into a similarly large divergence in corporate earnings estimates. The sell-side analysts’ consensus for 2023 is still approximately $235 per share for the S&P 500 Index, for example, while skeptical investors put the figure closer to $200. Where we end up will likely depend on the economy, but also on how much inflation declines.
Should defeating stubborn inflation require a recession, and S&P 500 earnings estimates for 2023 fall from $235 per share to something more like $200 (a drop of 15%, equal to the average earnings decline in a post-war recession), that would suggest further downside in equity markets.
By contrast, a rollover of inflation (driven by some of those infamous “transitory” factors) could lead to a pivot in monetary policy. That could enable investors to start pricing for a milder slowdown, building a base for recovery, identifying winners and losers more clearly, and putting some of the volatility of 2022 behind them.
So, what do we think third-quarter earnings have told us so far?
One important story to emerge is the growing dispersion between the poor performance of technology companies (many of which are now enduring a comedown after the extraordinary pull-forward in demand during the pandemic years of 2020 and 2021) and the resilience of other cyclical sectors (which suggests that the tech industry’s woes are sector-specific rather than due to broader economic weakness).
With 50% of the S&P 500 having reported as we write, FactSet data suggests that earnings per share in the technology and communication services are down 3% and 19%, respectively in the third quarter—with interactive media down 32%. By contrast, industrials earnings are up 16% and consumer discretionary earnings are up 13% (despite internet retail being down more than 9%).
These cyclical sectors are where one might expect to see struggles with a weakening economy. Two companies that are traditionally regarded as bellwethers for the global economy—Caterpillar, the world’s largest construction equipment manufacturer, and Honeywell, the industrial conglomerate—beat analysts’ earnings estimates and offered confident guidance. That appears to fit with better-than-expected 2.6% U.S. GDP growth in the third quarter. We see a similar pattern in the substantial outperformance, so far, in third-quarter earnings from the EAFE Index versus the more tech-heavy S&P 500 Index.
Big Tech Punished
When we look in detail at last week’s disappointing third-quarter reports from five of the biggest names in the U.S. market, a flagging economy does not appear to be the main culprit.
Alphabet (aka Google) missed analysts’ estimates in part due to lower-than-expected advertising revenue growth. That might suggest broader economic weakness. Its plans to slow hiring will help take some heat out of the U.S. jobs market. But other factors included disappointing YouTube revenues and ongoing privacy and regulatory headwinds. These likely reflect high benchmarks set during the pandemic years of 2020 and 2021 and idiosyncratic technology sector issues rather than difficult macroeconomic conditions.
Like Alphabet, investors punished Meta for a disastrous quarter driven by weak advertising revenues, but also idiosyncratic issues such as competition from TikTok, privacy challenges and growing losses from the company’s investments in the metaverse.
Microsoft beat analysts’ revenue expectations, but then gave disappointing guidance on future growth for its cloud-computing division. Again, that’s likely a symptom of the tech boom of 2020 and 2021 rather than fundamental weakness in the economy.
Amazon shares slumped after warning that the consumer was in “uncharted waters” and giving disappointing guidance for the holiday season. But revenue and sales for its online store grew in the third quarter. The bigger current challenges appear to be managing warehouse and logistics costs, and in its cloud-computing business, which we think is well positioned for the longer term, but faces near-term concerns around growth and margins, particularly given 2021 comparisons. It’s worth noting that shares in Amazon’s online-shopping competitor, Shopify, rose sharply largely because it was able to show that its own logistic investments this year had contributed to growth.
We also had results from Apple, perhaps the most consumer-sensitive of our U.S. top-five, and on this occasion the one upbeat story from Big Tech. It beat analysts’ estimates for third-quarter revenues and earnings despite foreign-exchange headwinds and the impact of China’s COVID lockdowns on iPhone supplies. Demand for the iPhone 14 appears solid, paid subscriptions to Apple TV and Music services are up 21% year-over-year, and the Mac division far outperformed expectations.
We have little doubt that leading indicators such as the U.S. housing market, retail sales and global Purchasing Managers’ Indices suggest a weakening economy, and that this will hit corporate earnings eventually, but it is not doing so yet. To reiterate, this quarter’s high-profile earnings misses have at least as much to do with technology’s bumper years in 2020 and 2021 as with broad economic weakness that might presage an easing of inflation.
Indeed, where we do see weakness, it reflects difficulties with inflation more than difficulties with demand: According to Credit Suisse data, after 40% of the S&P 500 had reported, third-quarter revenues (which are reported in nominal dollars, and not adjusted for inflation) were up by almost 10%, year-over-year, while earnings (also nominal) were up 1.6%. As a result, while earnings are still up, profit margins have shrunk considerably.
We think that leaves equity markets with the uncertainty described earlier. The current volatility—including potentially deceptive rallies—reflects this uncertainty.
More earnings data and more guidance from companies should help to clarify the situation, but for now, we are erring on the side of caution: We do not assume that the inflation and bear-market monsters are dead yet.
It is Halloween, after all.
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