05 June 2023 Equities | US

Earnings Outlook: Equities Skirt Risks of a Sharp Downturn

Summary

For all the hot air it generated, markets were correct to simply ignore the ongoing drama around the debt ceiling and outlook for Federal Reserve (Fed) policy.
Even with yet another robust jobs report, the Fed seems determined to stick with the dovish stance toward inflation. Its only priority is employment.
We remain neutral on equities given the mixed earnings and a fading consumer, especially among lower-income people. But barring some major shock, we see little risk of a major selloff.
One yellow flag is the NASDAQ 100, which is now running 38% above our earnings benchmark.
Only 15 companies report this week. RV maker Thor Industries and upscale Vail Resorts will likely give very different views of how consumers are spending discretionary dollars.

What We Learned Last Week

We got reassurance on two issues that had been worrying us – the debt ceiling and outlook for Fed policy.

Bye-Bye MAGA – The great debt ceiling fight turned out to be largely a non-event. We knew a deal would get done, but we expected it to go into overtime, with a market selloff pushing recalcitrant legislators to do what had to be done.

Instead, Mr. Market – who kept bidding equities up during the war of words – was right all along. After watching the MAGA crowd go down to defeat during the 2018 midterms, the election of 2020 and yet again in the 2022 midterms, Mr. Market surmised that the MAGA threat has largely dissipated.

Fed Doves Prevail Again – And the latest employment report shows that the Fed’s campaign to raise rates has done little to cool either the economy or inflation. Rather than signal that it will have to apply the brakes harder in coming months, the Fed focused on a slightly slower-than-expected increase in hourly wages (4.3% YoY versus 4.4% expected) to apparently lean toward remaining on hold.

Therefore, the Fed continues its extraordinarily dovish stance toward inflation. Yet in the past, the Fed has had to raise Fed Funds at least two points above inflation to curb it.

Earnings Are Mixed

Investors continue to punish companies that miss expectations and reward the apparent high-flyers. One casualty this past week was Saleforce Inc (CRM), which fell 4.6% on a soft revenue outlook. On the other hand, Cisco (CSCO) was up 3.3% on strong demand for its networking gear. Companies are picking their spots for how they spend CAPEX dollars.

On retail, discounter Dollar General (DG) plunged 20%. Its customers are skewed toward lower income, and they are only buying necessities – they have substantially cut spending on higher-margin discretionary goods. Macy’s (M) earnings report was gloomy – same-store sales fell 8.7% with a soft outlook for H2. About half of its customers earn less than $75,000/year.

But upscale retailers continue to do well. Lululemon Athletica (LULU), Nordstrom (JWN) and Five Below (FIVE) all rallied as wealthier consumers continued to spend – although signs of caution are appearing.

The broad economy and labour market may still be posting good numbers. But for people in the lower two-thirds of the income distribution, the only thing separating them from recession is their job. That may not hurt markets for now, but it could be a contentious issue for next year’s election.

We Like the Dip

Mr. Market has been correct all along that the Fed is not serious about fighting inflation – its only priority is maintaining full employment. Until the Fed shows by its actions (forget the talk) that it will do whatever it takes to control inflation, markets are at little risk of a major selloff, barring some unexpected exogenous shock.

Meanwhile, given the combination of strong and weak earnings reports, we doubt markets can rally significantly. We retain our neutral stance; however, we relax our concerns about a selloff that could take equities to the lower end of the trading range of the past year.

Barring some major shock, we expect investors will buy into any selloff.

Lastly, it would be folly to oppose the ongoing tech rally. But we must also note that the NASDAQ 100 is running 38% ahead of our earnings benchmark. If (or when) the AI bubble bursts, the tech correction could be quite sharp. (See Equity View: Reality-Check Time for AI and Nvidia)

The Week Ahead

It will be a quiet week for earnings, with only 15 companies in our Russell 1000 universe scheduled to report.

Tuesday

Casy’s General Stores (CASY) vendor of gasoline and convenience items is probably benefiting from more Americans on the road.
Ciena Corp (CIEN) offers another take on corporate demand for network gear.
JM Smuckers (SJM) will likely follow most other brand-name food companies with impressive price hikes.
Thor Industries (THO), maker of RVs, faces the best and worst of current market conditions: unprecedented demand for travel and a freeze on big-ticket discretionary items.

Wednesday

Alcoholic beverage maker Brown-Forman (BF/A) may benefit from still strong demand for eating out.
Campbell Soup Co (CPB) gives another take on how much inflation consumers will tolerate for name-brand foods.
Given its run as a meme darling during the pandemic, GameStop Corp (GME) will get far more attention than its modest $7.5bn market cap would otherwise merit.
Discount department store Ollie’s Basement (OLLI) will probably be hurting, like other retailers catering to lower-income people.