Most economists and analysts have come around to embracing the rising odds for recession this year. Yet, for all the talk, that eventuality does not appear to be reflected in current corporate earnings forecasts. Indeed, the majority of professional advisers, fund managers and analysts are still talking up — to get your money. According to service provider FactSet, 55% of the S&P 500 stock recommendations currently are “buys” and 39% are “holds” with only 6% “sells”. This is unsurprising, since they all have a vested interest in talking up earnings and expectations, and stock prices.
Many are still holding out hope that the economic slowdown-contraction will be brief and shallow, and that central banks will be the first to blink and pause the current monetary tightening cycle. Case in point, futures trading indicates that the interest rate will peak below the US Federal Reserve’s median projection of 5.1% — in fact, betting that interest rates will start to drop sometime in 2H2023. This is contrary to what the Fed itself has been signalling — that there will not be any interest rate cut this year and any perception that its commitment to the 2% inflation target is flagging, is misplaced.
Charts 1 and 2 show the historical as well as the 2023-2024 analysts’ forecasts for sales and profits for companies that make up the S&P 500 and MSCI World Index. While analysts have been paring back their forecasts, very slowly, both sales and profits are still expected to expand in the coming two years. Critically, profit margins are expected to widen to record high levels — amid a global economic slowdown, if not outright recession, no less. For example, net margins for S&P 500 companies are currently estimated at 12.8% and 13.5% in 2023 and 2024 respectively, up from the projected 12.1% in 2022 and 11.1% in 2019 (pre-pandemic). We find that hard to believe. Perhaps, in addition to vested interests, many are also guilty of recency bias (where one gives greater importance to the most recent events).
After all, for more than a decade (since the global financial crisis), companies had enjoyed ever-increasing profitability, fuelled in no small part by massive liquidity and cheap money. Extreme monetary policies — enabled by the secular decline in global inflation — drove interest costs lower and lower to near zero and even negative in some countries, underpinning a sustained period of economic growth and stock-bond market gains. Against this “boom-time” backdrop, companies were able to raise selling prices even as costs fell, translating into fatter margins and profits. Returns to shareholders soared.
See also: Arguments for keeping domestic interest rates relatively low
In fact, if we go back further, corporate profit margins have been trending broadly higher since the early 2000s, save for the brief dips during the recession years (see Chart 2). According to the US Bureau of Economic Analysis, records dating back to the late1940s show that corporate after-tax profits as a percentage of GDP have risen steeply in the last 20 or so years, and are currently hovering at all-time highs (see Chart 3). In effect, that means a rising share of past productivity gains have accrued to capital owners, at the expense of labour.
There are many contributing factors for this phenomenon, not least of which is globalisation and cost-optimisation of global supply chains. (We wrote about the other key drivers in our previous article, “The golden decades of broad-based wealth creation (accumulation) are over” in Issue 1442, dated Oct 10, 2022.) China’s membership into the World Trade Organization in December 2001 was a high watermark and the biggest symbol of globalisation. The country provided a huge supply of cheap labour to the world, driving manufacturing costs lower while diminishing labour bargaining power everywhere else, especially in developed economies. Globalisation is, in turn, one of the main reasons for the secular decline in inflation rates.
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The thing is, some of these powerful secular trends are reversing. The pandemic and geopolitics have shifted the focus from cost optimisation to national security and supply chain resilience — in other words, the trend moving forward is deglobalisation. The decoupling between the US-led West and China, the Russian-Ukrainian war, weaponisation of the US dollar, payment systems and trade as well as rising protectionism and immigration friction are leading towards a more fractured global market. And the world is likely at the lower limits of taxation minimisation — the US is leading efforts to establish a global minimum tax — and deregulation. All of the above are inevitably cost inflationary, at least for the near-medium term — and will quite likely bring about an end to the current golden era of falling costs and rising corporate profitability.
Money talks, bullshit walks
Market analysts may be paying lip service to recession scenarios, but their actions — in terms of earnings forecasts and positive recommendations on stocks — say otherwise. As we said, they have vested interest in talking up markets. Words are cheap. Are they putting money where their mouth is?
Notably, corporate insiders — whom we presume would have a far better grasp of their business prospects — are not buying their own stocks yet, despite the recent market decline. Insider sentiment (measured by the trailing three-month average ratio of companies whose executives or directors have been buying stock versus selling) has dropped for six consecutive months, according to data from InsiderSentiment.com (see Chart 4).
The fact that company insiders are not buying into the positive analyst recommendations with their own money should tell us something — that the worst may not be over just yet. For one, the market, we think, is too optimistic on a Fed pivot. Considering all the above-mentioned factors that are cost inflationary, we suspect the inflation rate is unlikely to drop to the central bank’s target 2% as quickly as investors hope.
Meanwhile, the labour market could stay tight even as the economy weakens, due in part to the ageing population and early retirements as well as behaviour changes post-pandemic. Case in point, the US labour market has remained remarkably resilient. The unemployment rate remains near 50-year lows at 3.5%. This will probably give the Fed the latitude to keep interest rates high for a sustained period, until it is rest assured that inflation is brought back under control. We pared our exposure to long-dated Treasuries last week — netting a smart 8.1% return on our average cost — cautious that recent bond gains may be underestimating how far yields could rise from hereon.
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Yes, inflation rates may have peaked — US inflation rates have declined for five consecutive months to 7.1% in November 2022, from the peak of 9.1% in June — as it should mathematically, due to the high base effect. But a lower inflation rate does not mean lower prices. Far from it. It just means prices are rising at a slower rate, compared with the previous corresponding period. The cumulative effect of high inflation rates over the past two years will negatively affect consumer purchasing power — even if the inflation rate drops to zero today — particularly as excess savings from the pandemic dwindles over the coming months. Indeed, we suspect much of the excess savings for the lower-income households are gone, given the high and rising prices for necessities such as energy and food.
Real wage growth has been negative across the globe, amid high inflation. According to the latest International Labour Organization (ILO) report, global monthly wages turned negative (-0.9%) in 1H2022, for the first time in more than two decades. Advanced G20 countries were the worst hit. In the US and Canada, average real wage growth was -3.2% in 1H2022 while that in the European Union (EU) was -2.4%. Negative real income growth would accentuate the global consumption slowdown.
Weakening purchasing power and demand will make it more difficult for companies to keep raising prices, to pass on higher costs. Case in point, Tesla made the headlines on Jan 6 after it cut prices in China — as well as in Japan, South Korea and Australia — for the second time in less than three months. Earlier, CEO Elon Musk warned that “radical interest rate changes had affected the affordability of all cars, new and used, and that Tesla could cut prices to sustain volume growth”.
With corporate margins at historical high levels, there is a lot of fat for companies to cut, in order to maintain their competitiveness and market shares. We think analysts and investors will need to recalibrate their longer-term expectations, away from what it has been in the past two decades, and towards a new normal of macroeconomic conditions going forward.
The Global Portfolio was up 2% for the week ended Jan 11, led by gains from Global X China Electric Vehicle and Battery ETF (+6.9%), Grab Holdings (+3.1%), and iShares 20+ Year Treasury Bond ETF (+2.8%). On the other hand, GoTo GojekTokopedia (-1.3%) and NEXT Funds Japan Bond ETF (-0.2%) ended lower last week. Total portfolio returns since inception now stand at 27.7%, trailing the MSCI World Net Return Index’s 39.9% returns over the same period.
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