S&P Global said its flash US Composite PMI Output Index, which tracks the manufacturing and services sectors, rose to 46.6 this month from a final reading of 45.0 in December. This was the first uptick since September; nevertheless, the index remains well below a key reading of 50 that is used to define contraction or growth in the private sector. Yet in a more worrisome sign in our view, the survey’s measures of input prices for both US services firms and goods producers rose month-over-month for the first time since last May. This bump in input prices may signal to the Federal Reserve that it needs to keep monetary policy tight and move interest rates higher if it is going to bring inflation back to its 2% target. And, inflation is a global problem as seen in Australian inflation, which shot to a 33-year high in the last quarter as the cost of travel and electricity jumped. Australia’s central bank is expected to raise interest rates again at a policy meeting next week. The Federal Reserve is expected to raise interest rates 25 basis points at its next meeting which ends on February 1.
The Debt Ceiling
Meanwhile, there are a few important issues brewing in the background. The current standoff in Washington over raising the $31.4 trillion federal debt ceiling is a significant risk to equity investors. Government shutdowns may seem like a routine part of governing since it has happened three times in the past 10 years. A partisan fight over healthcare spending led to a 16-day shutdown in October 2013. Disputes over immigration led to a three-day shutdown in January 2018 and a 35-day shutdown between December 2018 and January 2019. Last week Treasury Secretary Janet Yellen indicated that although the country has reached its current $31.4 trillion borrowing cap, the Treasury can continue to pay its bills until June by shuffling money between various accounts. But after that point, when the “normal” extraordinary measures are exhausted, the Treasury would run out of money from tax receipts to cover bond payments, workers’ salaries, Social Security checks and other bills. In short, the US Congress has a five-month window to find a solution, but a missed debt payment by the US government would send shockwaves through the global financial markets.
This week the US Justice Department took a big step toward reducing big tech dominance when it accused Alphabet Inc.’s (GOOGL.O – $97.70) Google of abusing its dominance in digital advertising. The government said Google should be forced to sell its ad manager suite, which generated about 12% of Google’s revenues in 2021, however this suite also plays a vital role in the search engine and cloud company’s overall sales. Advertising is responsible for about 80% of Google’s revenue. The federal government also said its Big Tech investigations and lawsuits are aimed at a group of powerful companies that include Amazon.com, Inc. (AMZN.O – $96.32), Facebook owner Meta Platforms, Inc. (META.O – $143.14) and Apple Inc. (AAPL.O – $142.53) with a goal of leveling the playing field so smaller rivals can compete. In our opinion, these government lawsuits also mean that earnings for many of the stock market’s biggest players and largest earners are unsustainable and are likely to come down. And while many of these stocks have been beaten down in the last twelve months and have rallied smartly in the early part of this year, their leadership role in the equity market is most likely over.
It’s All About Earnings
The stock market has been driven wildly up and down in recent months based upon its changing view of inflation and Fed policy. However, the actual performance of the equity market will be ultimately based upon the pace of economic activity and the trend in earnings. The initial estimate for fourth quarter GDP will be released later this week, but the data for third quarter GDP showed that corporate profits at the end of September were basically unchanged year-over-year. According to S&P Dow Jones, S&P 500 profits are estimated to be negative on a year-over-year basis in the fourth quarter. Note that S&P earnings growth has turned negative only 15 times since 1946, and eleven of those times it was linked to an economic recession. See page 7.
Moreover, the relationship between GDP and S&P earnings is meaningful since the two are highly correlated. Therefore, it is also meaningful that S&P earnings have been outperforming GDP since June 2020, due in large part to post-pandemic stimulus that has now ended. In short, both monetary and fiscal stimulus gave a temporary and artificial boost to earnings growth for a time. However, whenever corporate earnings have been outperforming underlying economic activity, history shows that this outperformance in earnings is unsustainable. In other words, outperformance is typically followed by underperformance. See page 7. This combined with the government’s attack on the business models of many large technology companies implies a risk to S&P earnings in the quarters ahead. Again, we would emphasize sectors and companies with defensive and predictable earnings growth streams such as energy, staples, utilities, aerospace & defense, and companies where the PE multiple is in line with the company’s earnings growth rate.
Weak Economic Signals
Signs of a slowing economy continue to grow, and this includes the third consecutive month of weakness in industrial production, and the tenth consecutive decline in the Conference Board Leading Economic Indicator. The LEI displayed widespread weakness in December, indicating deteriorating conditions for labor markets, manufacturing, housing, and financial markets. Conference Board economists have indicated that the persistent weakness in the LEI is signaling a recession in the near term. See page 3.
Historically, home prices and retail sales have been strongly correlated and both have been decelerating for all of 2022. Worrisome for us is the fact that real retail sales (adjusted for inflation) have been negative in five of the last ten months. Negative readings have been linked to recessions. Also note that as the Fed continues to raise rates, the affordability of homes is deteriorating and is apt to send the residential housing market into a deeper recession. See page 4. Although the NAHB Single-Family Index has been declining since its peak in November 2020, January’s survey experienced a small increase from recessionary levels. Meanwhile, December’s new residential permits and housing starts were down 29.9% YOY and 21.8% YOY, respectively. See page 5. New home sales in November were 15.3% lower than a year earlier, down to an annualized level of 640,000 units. Existing home sales were down 34% YOY in December to a new cyclical low of 4.02 million units on an annualized basis. As seen on page 6, similar declines have occurred in recession years. In sum, January’s rally has been impressive in many ways, and we particularly like the breakout in the Russell 2000 chart (see page 9) but there are storm clouds on the horizon. We fear prices are beginning to price in a Fed pivot and this would be premature. We remain cautious.
PLEASE NOTE: Unless otherwise stated, the firm and any affiliated person or entity 1) either does not own any, or owns less than 1%, of the outstanding shares of any public company mentioned, 2) does not receive, and has not within the past 12 months received, investment banking compensation or other compensation from any public company mentioned, and 3) does not expect within the next three months to receive investment banking compensation or other compensation from any public company mentioned. The firm does not currently make markets in any public securities.