Earnings Parade – Positive Surprises, But Equities Unimpressed

Summary

• Q1 earnings so far are posting an impressive average 6%+ beat so far – well above the 2% level of recent quarters.
• This likely reflects low expectations – but many companies have also been surprisingly successful at passing on higher prices well above recent inflation rates.
• There are signs of weakness, especially in companies that produce products for consumer electronics. And corporate CAPEX budgets seem to be tightening.
• But no company so far is warning of recession risks; the general view seems to be of a robust economy overall.

Market Implications

• Despite the generally positive tone, the S&P 500 and NASDAQ 100 have not rallied above a narrow range.
• Maybe those solid results are making the hoped-for rate cuts less likely.
• We see little to push equities out of the past year’s trading range for now, whether up or down. We still think medium-term risks are to the downside.

Earnings Surprise to the Upside So Far

Two weeks into the Q1 earnings season, results are generally good. The major indices (S&P 500 (SPX), NASDAQ 100 (NDX) and Russell 1000 (RIY)) are posting average beats of 6-6.5%, considerably higher than the 2% or so of recent quarters. Yet markets do not seem overly excited – SPX is up 0.8% and NDX a scant 0.25% over that period.

Clearly, it is less that many companies are doing great and more that expectations were low.

So far, the only weakness has been the consumer goods sector, especially consumer electronics. Microsoft (MSFT), for example, reported much better than expected earnings on growth in its cloud business and a pickup in search activity since ChatGPT technology was introduced into its search engine, BING – but Windows-related software sales were down on weakness in PC demand.

Many other companies/sectors have been surprisingly strong.

Consumer Staples – Procter and Gamble (PG), Coca-Cola (KO) and PepsiCo (PEP) all reported much better than expected results. The general message was that volumes were stabilizing after declining in 2022 on higher prices – and that these companies had pushed through price increases on order of 10%(!) during Q1 with little apparent impact on volumes.

That seems remarkable, especially given that wages have (so far) trailed reported inflation.

Could this be a systemic trend across the sector?

Homebuilders – So far, DR Horton (DHI) and Pulte Homes (PHM) have reported strong results. Because of the shortage of available existing home listing, homebuilders are pivoting toward new houses for first-time buyers – and finding a receptive audience. We unwound our short position in the homebuilder XHB on 21 April as it became apparent that a slow housing market will not stop homebuilders from making money. We have not put on the opposite trade (long XHB/short SPY) because XHB contains various names in the retail and construction sector that are doing poorly.

Tech – Earnings from the likes of Alphabet (GOOG), Microsoft (MSFT), and Meta Platforms (META) have been much better than expected, largely because of strong demand for cloud technology. But as with MSFT, there are also weaknesses – such as in online advertising. This, for us, is a key indicator of underlying confidence in the outlook.

Other companies more exposed to the consumer electronics sector, such as Texas Instruments (TXN) and Corning Glassworks (GLW, which makes glass screens for PCs and many other products), have reported weak results. In a sign that corporate IT budgets are tightening, Juniper Networks (JNPR) and Cadence Design (CDNS), which provide internet networking technology and services, reported slowing orders. That may explain the NDX index’s limited response to the performance of the tech giants.

Industrials – We see a mixed bag here. Schwinn Williams reported strong demand for paints and coatings and confirmed a solid outlook. Caterpillar (CAT), maker of earthmoving equipment, also reported strong results and a good outlook. But Packaging Corp (PKG), which makes boxes to move stuff, disappointed. United Parcel Service (UPS) reported declining package volumes. Volumes were down 3% in 2022 and are expected to drop another 3% in 2023. Dow Chemical (DOW) is seeing good demand in speciality chemicals, pharmaceuticals, and energy sectors, but weakness in consumer durables, construction, and industrial end markets.

Metals – Companies in steel and aluminium report solid order books and expectations for 2023. These include Steel Dynamics (STLD), Nucor (NUE), and Alcoa (AA). They indicate strong non-residential construction demand.

Key Takeaways So Far

Earnings so far give little indication of an economy at risk of recession, even when earnings disappoint. Companies are not highlighting recession as a risk.

We had expected more warnings about risks in H2, especially if the Federal Reserve (Fed) remains on hold with no rate cuts in the works, or concerns about tightening credit conditions. Maybe the Silicon Valley Bank crisis came too late in the quarter to be a factor in either earnings or outlooks.

We still see a material risk of an economic slowdown and recession. But this will more likely be a very slow-moving trainwreck that comes late in the year or in 2024.

For now, we continue to see equities trading in a narrow range, with no catalyst to push them much higher or lower.

Any indication that the Fed might cut rates would surely spark a rally – but robust earnings (and inflationary price hikes) so far probably make a rate cut any time soon unlikely.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)