As the fourth quarter 2022 earnings season gets into full swing, many investors remain on the sidelines. Whilst there are good reasons for being vigilant, we would caution against too much pessimism.
US leading economic indicators have for six months been warning of an upcoming recession. Should it materialise, it will be by far the most anticipated US recession in over 50 years. Analysts and investors’ expectations have been well tempered already, with consensus GDP growth for 2023 remaining marginally positive (+0.4%), with a mild recovery in 2024 (+1.3%). The general perception is therefore that we may face potentially only a mild US recession, if any.
US GDP growth vs S&P 500 sales growth (%)
S&P 500 index sales have thus far held up well (+11% in 3Q2022), supported by continuing economic expansion and boosted by inflation, but constrained by a huge dollar currency headwind. General consumption is currently holding up well and with the dollar turning into a tailwind, we believe S&P 500 index sales can continue growing, at around mid-single digits over the current reporting season. This may seem to be quite a moderation, but still close to long-term average numbers.
S&P 500 sales growth vs operating margin (%)
Investors will watch top lines closely to understand whether their businesses are able to continue growing organically and pass through rising costs. Technology investors will be particularly alert to the top-line growth of their cloud investments. They have been relying on its super growth levels and strong cash flow support, which showed some signs of maturing in the previous earnings season.
Further, they will be very interested in comments from Alphabet and Microsoft around their respective plans in DeepMind and Bing to understand whether AI applications are now going to become a major feature - and whether such a war between them is potentially in the making.
Pandemic effects
The recovery from pandemic-inflicted supply chain complications is anything but done yet. It takes time for these activities to fully normalise and there are further productivity gains to materialise. The auto industry, for instance, is still held back by a shortage of specialist semiconductors.
We are relatively relaxed about potential top-line organic performance, but we have some reservations about potential changes in profitability. Over time operating margins follow sales growth, and as with the recent drop in the latter, margins have already peaked in the second quarter of last year. That said, they are still well ahead of historic peak levels, and many fear a potential mean reversion and risk of a further material potential drop in margins and therefore in earnings.
S&P 500 operating margin vs capacity utilisation (%)
Capacity utilisation is a critical factor in business profitability (see the above chart). It is currently stable at recent historic peak levels but many fear it may now drop, presenting a threat to profitability. We, though, also believe investors should consider current issues around the creation of new capacity. Due to Covid, capital expenditures here have been cut back materially. Recent growth in capex has been running at around a fifth off the low base during the pandemic, and this new (and the updated) capacity is running at a high utilisation level and delivers additional profits.
No earnings collapse – but some firms under threat
With less fear of a material general potential earnings collapse this quarter, we nevertheless have grave concerns about businesses that have overextended themselves. We already see material headcount layoffs in the technology sector, and we must be very sure about the financial disciplines and controls in a business. Many investors underestimate the importance of the CFO to protect their wealth, and especially so under the current more uncertain economic conditions.
The sharp drop in US headline inflation is very welcome, but it takes time to reflect in operating costs. Wage growth has also started receding. We are conscious, though, that it is too early to see these benefits yet materialising in operating results. Even more so this year, it is dangerous for investors to simply base their decisions on macro-economic factors and subjective views.
It seems most businesses have used the opportunity during the ultra-low interest rate environment to fix most of their rates. With the structurally higher rate environment since, investors will now focus on the interest bill to understand how vulnerable the business actually is, especially those with high or increased gearing.
China re-opening
The re-opening of the Chinese economy is an important global economic factor this year. Its exports collapsed (-10%) and imports stagnated last year, whilst world trade grew in double digits. The improved supply and demand from China can hopefully now better support global trade, and therefore business profitability. China’s share of world trade has halved to 13%, and a turnaround can be positive for most parties.
Overall, we believe the current reporting season will be less of a top-line issue and more of an operating margin issue. The correct interpretation of costs and margins is even more paramount this time. We have done our research homework in this context and feel we have little to fear for our particular holdings. We can also capitalise on those who may overreact to the negative on particular quality businesses.
Gerrit Smit is the manager of the Stonehage Fleming Global Best Ideas Equity fund. The views expressed above should not be taken as investment advice.