Counterintuitive

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  By Guest Blogger Doug Rowat

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What the market needs this year is weak corporate earnings.

Needless to say, an unexpected statement from a portfolio manager who has frequently gone on the record to highlight the high correlation between market direction and corporate profit growth.

However, this year may, in fact, be different. The S&P 500’s Q4 earnings results, which wrapped up at end-February, were unimpressive (roughly a 6% y-o-y earnings decline), but the market reacted inversely with the S&P 500 gaining about 4.5% through the first two months of the year.

Why? Because with an equity market obsessed by inflation, 2023 is shaping up to be a year disruptive to traditional data relationships. Good market data is being perceived negatively (inflation inducing), while bad market data is being perceived positively (the economy’s cooling). Simply put, bad market data signals that central banks are winning the battle against inflation.

And so far, slowly but surely, that battle’s being won. If US headline CPI continues to moderate, as it’s done for eight consecutive months now, then markets will likely advance. In fact, this week’s positive February CPI results (a 6.0% y-o-y increase in prices, down from January’s 6.4% y-o-y increase) were influential enough that they managed to halt the downtrend caused by the US regional-bank crisis with the S&P 500 trading up almost 2% on the news.

Turning the corner: US headline CPI (y/y%)

Source: US Department of Labor; Turner Investments

So what does slower or even negative profit growth signal to the market? It signals a potential slowdown of the US labour market. It’s the strength of the jobs market that has been the biggest thorn in the side of the US Federal Reserve in recent months. The US unemployment rate remains at a 50-year low. It’s hard to control inflation when you have a fully employed (and hence free-spending) consumer.

As the US economy roared back from the pandemic lockdowns of 2020, US non-farm payrolls (a monthly measure of new jobs created) were frequently in excess of 600,000 per month throughout 2021. This was good, as we needed a post-Covid jobs recovery, but when the Ukraine war broke out, a much more serious inflation problem developed. At this point, weaker jobs numbers were desirable.

Beginning in summer 2022, an encouraging trend emerged as the US recorded five consecutive months of steadily moderating jobs growth—monthly non-farm payrolls drifted from a high of almost 570,000 to less than 240,000 by year-end. Unfortunately, the trend so far this year has been less than favourable with the US posting monster non-farm payroll results for January and February, both well in excess of economist expectations.

So how do you ultimately achieve slower job growth? It starts with corporate profitability. If companies are making less, they’ll lay off workers. This has begun in the tech sector, of course, which has recorded some of the steepest earnings declines of any sector in recent quarters. Just this past week, for example, Meta announced that it was laying off another 10,000 workers—on top of the 13,000 it laid off in November.

Standard Chartered Bank tracks layoffs in the tech sector. Layoffs have, naturally, spiked; however, it’s the non-tech sector that needs to catch up:

Information technology monthly layoffs (000s) vs non-information technology layoffs (000s)

Source: Standard Chartered Research, 3-month moving average

Normally, no investor wants an earnings recession, but this is 2023, and earnings weakness—because of its implied relationship to a cooling of the labour market—may be welcomed by investors. And an earnings recession appears inevitable at this point as consensus expects a 9% y-o-y earnings decline in Q1 followed by another 7% decline in Q2. Earnings growth is poised to rebound in the second half however:

US quarterly earnings (green column) & revenue (orange column) growth (y/y)

Source: Zacks Investment Research

It’ll no doubt require a delicate unfolding of events, but if an earnings decline over the next few quarters has the knock-on effect of slowing the labour market and if earnings then bounce back in the second half, a positive overall year for equity markets remains a likelihood.

I didn’t think I’d be in a position to question my assumptions regarding the positive correlation between corporate earnings and equity-market direction, but in the past year, up is down and down is up. As Wharton School professor Adam Grant highlights in his book, Think Again, sometimes it’s necessary to question old assumptions.

It’s a hard thing to do and in Grant’s words “it requires us to admit that the facts may have changed, that what was once right may now be wrong.” Such admissions are tough as the old views are comforting.

But the facts have changed. And, for this year at least, it’s my view that weak earnings will—counterintuitively—drive equity markets higher.

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Finally, do bloggers like myself read other bloggers? You bet. And I came across this insight recently from Barry Ritholtz, who was, ironically, himself referencing a fellow blogger. It’s not earth-shattering wisdom, but it’s wisdom worth being reminded of:

As [Michael] Batnick points out, all of these horrendous periods of market pain are already factored into long-term returns of equities. Meaning you do not get the 8-10% long-term gains without living through a significant number of market events, ranging from cyclical drawdowns to longer secular bear markets, and full-on crashes. It is all part of the dynamics of risk markets that by definition go up and down.

To state the obvious: “If you want to be there for the good times, you must also suffer through the bad times.” It is a too often forgotten cliché.

Is it cliché to repeat someone else’s cliché? Perhaps, but Ritholtz’s cliché is a good one, so don’t forget it.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.