At this late stage of the 2023 first quarter earnings season, it's time to start moving forward to what lies beyond those reports. But first, it's worthwhile to look at the numbers. According to FactSet, S&P 500 companies are recording their best performance relative to analyst expectations since the fourth quarter of 2021:
Both the number of companies reporting positive earnings-per-share (EPS) surprises and the magnitude of these earnings surprises are better than their 10-year averages:
There was fear of an “earnings apocalypse,” with called for an earnings decline of 6.7%. But that hasn’t materialized. The decline has been just 2.2% which is nowhere close to the feared “apocalypse”.
Moving to revenue, the situation is similarly better than expected:
Also, the blended revenue growth rate for last quarter was 3.9%. That’s well above the initial expectation of 1.9%.
Taking all this into account, the forward 12-month price-to-earnings ratio for the S&P 500 is now 17.7. That’s less than the five-year average of 18.6.
Given the Federal Reserve’s historic actions, these earnings results are quite good and a pleasant surprise. But that’s in the past now.
What Lies Ahead?
Turning to current data, let’s address inflation. Last Wednesday we received April 2023 inflation numbers, which were better than expected.
The consumer price index (CPI) increased 0.4% for the month, equating to an annual increase of 4.9%, which is less than the 5.0% estimates. The market initially reacted positively to the news because this data provides support for a pause in interest rate increases by the Fed.
Most importantly, the biggest contributor to the CPI jump was shelter costs, which increased another 0.4% and are now up 8.1% from a year ago. This may seem negative, but shelter costs are the slowest lagging piece of overall inflation. For them to be the biggest contributor is a positive because that means other areas are declining. Thus, we can realistically expect shelter costs to begin to decrease rapidly over the next three to nine months.
The CPI report reaffirms that inflation is continuing to cool, thanks to rate hikes – or perhaps despite them. This trend continuing would bring inflation down to a level more in line with what we’ve seen over the past six years:
The inflation data is particularly positive when looking at the goods side of the equation. Goods inflation is decreasing faster than overall inflation, which will further accelerate the drop throughout the rest of the year (shipping costs are sinking too):
Now, we must remember the second part of the Fed’s mandate – jobs. The Job Openings and Labor Turnover Survey (JOLTS) report from almost two weeks ago shows a tightening of the labor market:
Do you agree? We ask because many talking heads are pointing to the most recent nonfarm payrolls print as contradictory information:
The table above reflects a 253,000 increase in nonfarm jobs, which is stronger than the expectation of 185,000. But that headline figure is misleading. Yes, nonfarm payrolls rose 253,000. But they were also revised down 149,000 for the prior two months, bringing the net gain to just 104,000. That figure aligns with the JOLTS data.
Taken together, we think it’s an indication that the labor market is tightening and unemployment will rise later this year. Should that occur, it will be another pressure point for rapidly decreasing inflation.
Furthermore, the leading economic indicator index (LEI) indicates a tightening economy, further pressuring inflation while also increasing the likelihood of a mild recession. This datapoint and others in this post may seem new to our readers – it’s true that we don’t mention them often – but they validate our base thesis of an upward market trend in late 2023/early 2024.
Here's some history on the LEI – the white line is the LEI, and the red columns are recessionary periods:
Using this same data, we included the lead times into recession once the LEI broke down significantly. The average lead time after the LEI moves deeply downward is about 7-8 months:
The current breakdown started basically in the first quarter. So, an average lead time would indicate a recession late in the second quarter or during the third, as we’ve discussed for some time.
All these data points seem to support the change in the most recent tone of the Fed meeting, where a language alteration is quite telling:
Old language:
“The committee anticipates that some...additional policy firming may be appropriate.”
New language:
“Determining the extent to which additional policy firming may be appropriate…”
The interpretation has broadly been that the Fed has hit its rate cycle ceiling or could at least introduce a pause in the process. The Wall Street Journal pointed out how the new language is similar to how officials concluded their interest rate increases in 2006.
This belief is fortified further by Treasurys surging after the Fed’s commentary. Investors reinforced bets that Fed rates will be lowered by the end of the year, despite Chairman Jerome Powell’s insistence otherwise.
We even saw this reflected in swap contracts for June, which are now pointing to the effective federal funds rates being lower than they are today. Essentially, the market is pricing in more than three cuts totaling about 75 basis points by the end of the year:
So, the market basically is counting on a recession coming, which will lead to a significant slowdown in economic activity. That would force the Fed’s hand, despite Chairman Powell’s statements.
Equity markets have already been pricing this in, as we've mentioned. It’s reflected in growth stocks, which is why technology and discretionary companies have been the big winners so far this year. This all sets up a battle between Fed words, jobs, and bank stress. If the current data is correct and reaffirms our base thesis, we still view the end of this year and early next year as positive for equity markets as they look past a soon-to-emerge brief recessionary period.
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