February 26, 2023

The Economy Strikes Back!

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Bottom Line:


Markets have fallen over the past couple of weeks as positive economic surprises have risen. In theory, more economic growth means more Fed policy restraint and more economic recession risk. Perhaps. But this simplistic algorithm overlooks the upside of more economic growth, which is more earnings growth. Analysts expect 2023 earnings to bottom out in the first quarter of 2023. Should GDP continue to surprise to the upside, earnings will follow. Markets will then have to recalibrate the balance between the surprising resilience of the economy and the surprising austerity of the Fed. Perhaps the economy can tolerate more than expected. If so, economists have underestimated growth, analysts have underestimated earnings, and investors have underestimated this market’s return potential.


The Full Story:


As expected, markets hit an air pocket after rallying strongly through the first six weeks of the year. With investor sentiment high as a spy balloon, it only took a few hotter-than-expected economic and inflation missiles to bring it down. That’s the irony of the market today. The market wants a mild recession because the Fed wants a mild recession. Without one, a stronger and more resilient economy goads the Fed into continually tightening policy, which increases the odds of a not-so-mild recession. So, perversely, positive economic surprises make for bad news. Note the following:


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The Citigroup Economic Surprise index represents the sum difference between official economic results and forecasts. A number greater than zero conveys a period of better-than-expected economic data, while a number less than zero conveys a period of worse-than-expected economic data. Notice that from the 3rd quarter of last year into January of this year, the Surprise percentage fell from +20% to -20%. This corresponded with a near 20% advance in the S&P 500. However, over the past couple of weeks, the index has shot higher from -20% to +34%. While that’s great news for Main Street, it’s bad news for Wall Street. The surprising economic results drove the US dollar, interest rates and rate expectations higher, while driving sentiment, valuations, and stock market indices lower. But if the economy grows instead of shrinking, are we sure that’s bad?


The Atlanta Fed updates its growth estimate for the current quarter with nearly every economic release. As expected, their forecast has risen as the positive economic surprises have risen:


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Per the Atlanta Fed’s estimate, the economy is on pace for a 2.7% growth rate in the first quarter compared with the Blue Chip economist’s flat to negative forecast for the quarter. This also follows a 2.7% GDP growth rate in the fourth quarter, hardly the stuff of recessions. Adding 6% inflation back to real GDP of 2.7% provides a nominal GDP growth rate of 8.7%. That rate better correlates with the corporate revenues opportunity as revenue and earnings reports do not subtract inflation. Therefore, more robust corporate revenues in the first quarter should ballast corporate earnings. If you haven’t hit your econ tolerance threshold yet, I have more. Headline inflation of 6% runs above wage inflation at 4%. That spread benefits corporations, not employees, further ballasting earnings.


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Therefore, the combination of stronger-than-expected economic data and headline inflation rates remaining above wage inflation rates suggests that economic and inflation surprises could translate into earnings surprises. Analysts currently expect Q1 revenues to grow an anemic 1.8% (consistent with the Blue Chip no growth forecasts) while earnings fall 5.7%, marking the lows for the year:


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Should the economy remain resilient, this forecast either must roll forward or revert as earnings track the economy higher. Nothing is certain, but the correlation between GDP growth and earnings growth over the last 30 years makes a compelling case for upside surprise:


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Surprising earnings growth either drives stock prices higher or stock valuations lower. Either way, the value proposition for investors improves.


Enjoy your Sunday!


David S. Waddell  

CEO, Chief Investment Strategist




Sources:  Goldman Sachs Global Investment Research, FactSet, FRED, Blue Chip, Citigroup


David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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