Markets this week renewed their interest in economic fundamentals only to fall prey to downside surprises. In our opinion, analysts have underestimated the negative impacts from weakness across trade and manufacturing. Now that other corners of the economy have started sliding in sympathy, expect forward earnings expectations to succumb as well. S&P 500 earnings are expected to shrink nearly 4% for the quarter just concluded, yet analysts still expect earnings will grow 11% for calendar year 2020. Ironically, this time last year analysts also expected earnings to grow 11% in the year ahead. As of today, those estimates have fallen below 2%. With history and foresight as a guide, we expect earnings expectations will follow the path of trade, manufacturing, and now services, applying additional downforce to equity prices. In response, we will maintain our hedge until expectations once again fall meaningfully below reality.
Markets this week quickly repriced lower as manufacturing and non-manufacturing data releases surprised to the downside. In fairness, the obsession with trade headlines has eclipsed all other investment-related subject matter for months. However, as fundamental investors, our attention has remained focused on the steady string of less-than-encouraging data releases. Economic deceleration isn’t fun to write or read about but as stewards of your hard-earned assets, we get paid to tell the truth! The rapid recalibration of expectations with reality this week was long overdue. But with the Dow down only 3.5% from its all-time high…is it over?
The end of every economic cycle has a villain. In the ‘80s, we had Volker. In the ‘90s, we had the S&L crisis. In the 2000s, we had the internet bubble. In the 2010s (rounding), we had the great financial crisis. What will the culprit be for the next recession? Should a recession begin tomorrow, it will likely be driven by the rise of populism and deglobalization. Rising nationalism and rising trade frictions have led to a global trade recession, triggering a global manufacturing recession:
Now, many pundits will assert that trade and manufacturing comprise a small portion of the US economy and statistically they are almost right. Manufacturing and US exports contribute 12% each to the US economy, with considerable overlap. Given the 70% contribution from US consumers, manufacturers and exporters appear almost irrelevant. However, if you consider all of the ancillary activities related to manufacturing such as transportation of manufactured goods etc., total GDP contribution rises to 30% by some estimates. Additionally, reclassifying trade as the combination of exports and imports boosts activity levels to 27% of GDP. Therefore, all-in trade and manufacturing GDP contributions are not 12% respectively, they are more like 30%+. Rightsized to that level, decelerations in trade and manufacturing should foretell decelerations across the economy, including the much larger US services economy. This bit of economic truth seemed uncontemplated by investors until this week:
Given the seemingly newfound linkage between trade, manufacturing, and the service economy among traders, should the next analytical iteration begin to question earnings estimates?
Advanced analytics are not required to recognize that a relationship exists between manufacturing levels and S&P 500 earnings levels. Earnings expectations have fallen throughout the course of the year. In fact, if earnings in the third quarter fall 3.7% as anticipated, it will mark the third quarter in a row of negative year-over-year earnings growth. Full year estimates for 2019 now reside near the flatline at +1.3%…but no worries…analysts expect revenues to rebound 6% in 2020 and earnings to vault 11%. Why so rosy? Most forward expectations result from company guidance, and companies tend to hold on to their guidance until forced to revise lower. For the coming quarter, 113 companies have issued forward guidance and 82 of those have guided lower. That’s above average and interestingly, technology represents the largest negative contributor. Technology also happens to get the largest share of its revenues (57%) from abroad. Given that semiconductors are the new ball bearings for the global economy, the following chart bears respecting:
With trade, manufacturing and tech earnings flashing warning signals for earnings, rosy forward guidance seems dubious. Yet as of today, current earnings expectations call for a dramatic rebound from currently depressed levels:
These forecasts certainly appear vulnerable given the current array of variables. Listen more closely to what companies say this earnings period than what they report. This could be the season where forward earnings expectations recalibrate with economic realities.
Have a great Sunday!