Corporate Margins, Earnings Growth, and Consumer Wealth

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Welcome market participants to another 3 Things in Credit.?I’m Van Hesser, Chief Strategist at KBRA.?Each week we bring you 3 Things impacting #creditmarkets that we think you should know about.?On the back of two arguably hot #economic prints—January jobs and retail sales—you all have become obsessed with characterizing the economic landing.?“Hard,” “softer,” “soft” and more recently “no.”?Don’t know about you, but no landing is the kind of thing that would keep me up at night.?

This week, our 3 Things are:

1. Corporate margins.?They’re falling, should we worry?
2. #Earnings growth.?It’s falling.?What does it signal?
3. #Consumerwealth.?It is constructive overall, but not for everyone.

Alright, let’s dig a bit deeper.?

Corporate margins.?

As this cycle—and every cycle—turns, gauging the impact of the hit to corporate earnings growth is arguably the single most important driver of performance across credit asset classes.?Corporate cash flows and profitability not only support its own borrowings, but but businesses employ the individuals whose spending accounts for nearly 70% of the economy, who pay taxes and who pay back consumer loans.?Businesses provide cash flows to infrastructure projects, pay rent commercial properties, and are an important source of tax revenue to state and local governments. ?So if you’re going to monitor one thing from a macro standpoint, make it corporate earnings growth.??

Before we get to our earnings analysis, let’s set the stage by understanding how this #economiccycle is different.?Specifically, the hallmarks of this one are:

1. This downturn is as well telegraphed as any, although timing is difficult to nail down due to oft-mentioned “long and variable lags” related to the Federal Reserve’s?tightening of financial conditions;
2. Extraordinary benefits of pandemic era stimulus and monetary accommodation are fading but will still be meaningful well into 2023;
3. Those benefits positioned both consumers and businesses advantageously for the most part to withstand the effects of contraction; and,
4. The financial system has remained sound.?

Drilling down into the performance of the corporate sector, operating margins in the aggregate have risen to or near record highs in 2022 among large-, mid-, and small-sized listed firms.?We attribute that strength to firms achieving positive operating leverage from improved pricing power, as customers’ stimulus-enhanced financial wherewithal made them less price-sensitive.?That enabled firms to pass along rising production costs.?At least thus far.?Predictably, as the impact of inflation and its cure, tightening of #financialconditions, starts to bite, demand from those customers has begun to wane or shift to lower cost alternatives.?

In response to what looks like tougher times ahead, managements are hunkering down, reducing costs where possible and delaying capital expenditure.?By the way, the benefit to managements of just how well telegraphed this downturn is proving to be, is time—time to plan for whatever that downturn ultimately throws at them.?The ability to manage thoughtfully and gradually into the downturn is another noteworthy point of differentiation between this cycle and past downturns triggered by a sudden shock.?

So how is this affecting corporate margins??To bring this into real time, we can look at operating margin trends for the S&P 500 in the current earnings season.?With 370 firms reporting (74%), there have been 41% positive surprises in operating margin, vs. 49% negative.?Overall, operating margin is expected to come in at 14.7% according to the Bloomberg consensus, that’s down from a recent high of 16.3% in Q2 2022, but still above the longer-term average.?

Margin trends get at the hard/soft/no landing debate.?Not to get caught up in semantics but, our view has been that we are indeed “landing,” from the supercharged, stimulus-fueled growth of 2021, something we’ve referred to as The Great Deceleration.?With the #FederalReserve (and central banks around the world for that matter) determined to fully tame 40-year inflation, we expect economic growth in the U.S. to slow to at least stall speed at some point over the course of 2023, with recession remaining a real possibility.?But perspective is important here.?An important consideration leaning against a harder landing scenario is the strength of the corporate sector coming into the downturn, something we see clearly in operating margins.?And we would also point out that operating margins correlate well with credit spreads, which helps to explain why spreads have held in so well.?

Alright, on to our second Thing, earnings growth.

So we see how margins have broken out to the upside in the wake of all of that stimulus, now let’s look at how it all comes together into earnings growth.?

If you look at the trend line, not so hot.?Over the last 5 quarters, year-over-year earnings growth for the S&P 500 has gone from +28% in Q4 2021 to +11% to +8% to +4% to minus 2% (that’s the estimate for the current quarter, Q4 2022).?And consensus is calling for the next two quarters—the first two quarters of 2023--to be -6% and -6%.?This has prompted one well-respected equity strategist to comment that the current earnings season is shaping up to be “one of the worst streaks we’ve seen in quite a while.”?If forecasts are right, this will add up to a bona-fide “earnings recession,” defined as at least two consecutive quarters of year-on-year earnings contraction.?Well that doesn’t sound so good.?And it doesn’t bode well for #credit broadly as an asset class.?What’s that about “no landing???”

But let’s put this in context.?The Fed is doing everything it can to slow the economy by raising rates at the fastest rate since the 1980s and running off its balance sheet.?Consumers are quickly running through pandemic era “excess savings” and businesses are becoming conservative, preserving cash and adjusting cost structures.?But let’s not lose sight of the magnitude of the earnings downdraft.?Here, we’re looking at down single digits year-on-year for three quarters.?Full year 2023 is expected to be down less than 1% from full-year 2022.?We would point out that the typical earnings downdraft in a garden variety recession is down 10-20%.?In a crisis, such as the GFC, earnings can be down 40% or more.?For additional context, It is also worth noting that earnings in 2023 are expected to be 35% higher than 2019.?And operating margin in 2023 expected to be 120 bp above 2019’s 14.1%.?

Now, we would be the first to admit that the full effect of the Fed’s tightening has yet to hit, and the recent “hot” prints in January, jobs and retail sales, suggest that the Fed could get even more aggressive in its rate hikes than was expected a month ago.?But for now, we are sticking to our view that this contraction will be one easily navigated by corporates with well executed business models and appropriate capital structures.?

Alright, on to our third Thing, nuances in consumer wealth.?

I had an interesting discussion internally the other day that got me thinking.?I was discussing the January retail sales report and immediately went back to something we’ve been talking about lately, namely consumer “excess savings,” fiscal stimulus that padded consumer savings by $2.7 trillion at its peak and still amounts to a trillion plus.?Surely that was behind the hot print.?

While that is no doubt part of the story, I was reminded that the extraordinary effect of excess savings does not extend equally across all strata of consumers.?According to the Federal Reserve, the top quartile of household income brackets hold half of excess savings, and this is the group that is not as likely to tap into that to support their lifestyle.?The bottom half of earners account for just 21% of the total.?And this data was at midyear.?This discrepancy has only gotten worse.?This is why you are seeing credit card borrowings spike higher.?This is why we are seeing bad debt in consumer lending rise.?

Now, if we take into account the rest of the U.S. consumer’s balance sheet as a source of strength to consumer spending a similar narrative emerges.?Household total assets rose 26% during Covid as residential housing and investment portfolio values soared on the back of federal support.?But those wealth gains were concentrated, as you would expect, among the wealthy.?In fact, the top 20% accounted for 70% of household assets.?

The point is, from an aggregate standpoint, all of that household wealth continues to support consumer spending, which reinforces our view of a softer landing.?But when considering the benefits of that wealth, it is important to understand how it all breaks down underneath the headline number.?

So, there you have it, 3 Things in Credit

1. Corporate margins.?They’re falling, But are likely to remain above longer term averages.
2. Earnings growth.?It’s falling.?But the particulars surrounding this downturn points to a soft landing.
3. Consumer wealth.?It is constructive overall, but not for everyone.

As always, thanks for joining us.?Don’t forget to check in on KBRA.com for our latest research, and ratings reports.?For those of you in the States, enjoy the holiday weekend.?See you next week.?