November 1, 2022
Stocks Should Recover Before The Economy Does
My wife and I are doing what a record numbers of others are these days: traveling. While Covid forced many of us to change and cancel trips, only our jobs and our rescue dog, Marty, complicate our ability to enjoy our new lives as empty-nesters!
I only mention this for context about our shared observations: For all the spending we see in airports, restaurants, hotels, shops, etc., something besides inflation is undermining the economy. And it’s very easy to see: low-wage jobs are not being filled. And it’s more than that. Many younger adults, and older ones, too, don’t want to return to their offices — especially if they’re commuting into a city. In my neck of the woods, Boston reports that pedestrian foot traffic is down by more than 40%. Anecdotally, I’d say it’s much more than that.
Moreover, there’s a heck of a lot of job-hopping. And a significant number of people, especially women, have simply left the workforce for lack of affordable child-care and even elder-care.
The shaded areas in the chart below show the recession-era "dips," but the longer-term trend is apparent.
Granted, low labor rates may be a short-term phenomenon that corrects as inflation continues to swallow up wage gains. Layoffs may also change employees’ indifference to their jobs. Regardless of the forces at work, the problem is forcing big and small businesses alike to increase wages. Notably, the Labor Department’s private-sector employment cost index rose 5% year over year versus an average of 2.2% in the years prior to the pandemic. Higher total compensation, coupled with the rising cost of energy and raw materials have pinched third-quarter earnings for many, and still more expect inflation to be a bigger problem in the fourth quarter. So far companies as disparate as PepsiCo and P&G have successfully passed along higher costs, but both warned that there are limits to what the consumer will tolerate. Indeed, sales for certain name-brand products are slipping as consumer loyalty wanes in favor of cheaper generics.
Against this backdrop of higher expenses, by-and-large, revenue and earnings growth aren’t looking that great. Most notably, there have been outsized disappointments by some of the largest tech companies (see table on p. 11). And not all companies are in the position to absorb or pass along their higher operating expenses.
According to earnings aggregator FactSet, mid-way through earnings season, the percentage of S&P 500 positive earnings surprises is below 5- and 10-year averages. In fact, year-over-year, S&P companies are reporting their worst rate of earnings growth since Q3 2020.
So why is it that the S&P 500 rallied 8.1% in October? Clearly it’s not because of what they just achieved profit-wise, but rather what the markets expect them to achieve several quarters from now.
The Basis For OptimismSetting aside corporate balance sheets for the moment, stocks enjoyed a big bounce late in the month when there were signs that the pace of inflation had moderated (at least when volatile energy prices are stripped out of the equation). Granted, there has been scant evidence that the Fed will take a pass on its next two opportunities to raise rates this year (in early November and late December). The hope is that two 0.50% rate hikes (or less) will suffice as the prior hikes are only now starting to work their way through the economy.
To that end, investors bet last month that the Fed’s aggressive tightening will ease, having only to raise rates enough to keep inflation on its current glidepath lower. Most importantly, there’s some optimism that a "soft landing" can be achieved. That outcome would be far kinder on corporate earnings than a hard landing!
While FactSet data suggest that third-quarter earnings will be mediocre, it also expects 2022 to be better than most expected only a few quarters ago: 7.5% growth for this year and just as much for 2023!
Given what we learned a week ago about the economy (that it grew 0.6% in the third quarter and 2.6% on an annualized basis), the reversal of two negative quarters remains a welcome surprise. And as mentioned, the labor market may be feeling inflation’s wrath, but people are working. Indeed, unemployment today is at the same pre-pandemic level it was two years ago: 3.5%. And even as inflation has decimated purchasing power (credit-card debt is rising and savings are being depleted), the labor market has grown 1.8% to 164.4 million people.
Another positive for stocks is valuations. As mentioned in Jack’s column on page 1, mid-cap stock valuations are more attractive than large-cap valuations. Unmentioned is this: thanks to the bear market and earnings generally holding up, virtually all types of stocks are significantly cheaper than they had been. That hasn’t been overlooked by longer-term investors, and so last month they were buying shares at perceived fire-sale prices.