Second Quarter Preview: A High Bar for Earnings Season

Jeff Buchbinder (00:00):

Hello everyone, and welcome to the latest LPL Market Signals Podcast. Jeff Buchbinder here with my friend and colleague Lawrence Gillum. Lawrence, how are you today?

Lawrence Gillum (00:11):

Well, I'm doing great, Jeff. Happy to be back on the podcast.

Jeff Buchbinder (00:14):

Well, glad to have you back. I've said it before, you put your stock guy and your bond guy together, it just makes sense, right?

Lawrence Gillum (00:23):

It's magical.

Jeff Buchbinder (00:24):

It's magical. We complement each other well. Diversifiers, you and I, all good stuff. So after we look at these lovely disclosures let's get into our agenda. It is Monday, July 17, 2023, as we're recording this. And this will be out and available to all of you on Tuesday. So agenda first, we're just going to recap last week, as we always do. The Nasdaq had its best week since March. The S&P was really close to doing the same, but there was a week in June, I think it was right in the middle of the month, where the S&P was just as strong. So, we'll call it the second-best week for the S&P since March. We're going to talk about earnings season, Q2 earnings need to be quite good, we think, to keep this market going higher.

Jeff Buchbinder (01:13):

The reason we are happy to have Lawrence here, is we're going to talk about high yield bonds, certainly don't want to hear about high yield bonds from your equity guy. So, we're going to talk high yield, which has actually been doing pretty well here lately. At least that's what Lawrence tells me. And then lastly, preview the week ahead. It's going to be a big week of earnings, of course, with some really big names, but only about 60 companies. So, I think retail sales will still get plenty of attention in addition to digesting the Chinese data that we just got. So, let's get into it. Starting with market recap. Here you see the performance table for last week. And you know, we haven't color coded this, but if we made this, you know, green up, red down, there would be a ton of green <laugh> on here.

Jeff Buchbinder (01:58):

Because you know, the S&P 2.4% last week, NASDAQ 3.3%, Russell 2000 small cap index, even better up 3.6%. And then you go down to the sectors or go over to the sectors, I should say, every sector higher, right? Defensives, cyclicals, natural resources, growth, value, everything. Now you know, normally we talk sectors first, because that's where we tend to get the most dispersion. But Lawrence, we got a big downdraft in the dollar last week, and that propped up international equities. So, you know, you see here, you're up three and a half percent. If you look at the EAFE and the emerging market indexes in dollars, you got, you know, close to 5% returns for the EAFE and that for EM. So really strong returns overseas. So, Lawrence, any comments on that, either the dollar piece or any of these indexes that jump out at you?

Lawrence Gillum (02:59):

Well, I just think that the breadth of winners last week and how normally you see winners and losers when you look at these performance figures. But it was such, I think, a relief perhaps after the CPI data came in weaker than expected that we saw markets rally across both the equity and fixed income markets. It was a good week last week.

Jeff Buchbinder (03:20):

Yes, you'll see the fixed income returns in a second. They were really strong as yields came down celebrating the good inflation numbers. I mean, if you just walked through the news last week nothing really mattered even as, even close to as much as the as the CPI reading, which was quite better than expected. Even the earnings were fine for the most part, but we didn't really see a lot of huge moves off of the earnings reports that we got last week. So, let's keep moving. So, I'll hit commodities real fast Lawrence, and then you can hit the bonds. So we've been seeing a pickup here. Here's the weak dollar story again. You're seeing a lot of that in the financial press. Industrial metals up over 4%. Precious metals up over 3%. when the dollar falls, you tend to see metals move even more than than crude oil or natural gas. So you got the international equities and metals enjoying certainly a a very strong week. And then over the bonds, Lawrence, more gains.

Lawrence Gillum (04:29):

Yep, more gains, which we're happy to see. You know, we've talked about this in our Midyear Outlook presentations that maybe the first half of the year wasn't in line with a lot of expectations for fixed income investors. You know, we've talked about too, that once the Fed is done, we're likely to see yields lower. And we had that first kind of initial reaction to lower CPI last week and maybe the Fed is getting closer to being done raising rates. So, we did see yields fall across the curve last week. I think the 10-year treasury yield was down about 30 basis points. It was above 4%. Now it's around 3.8 something percent as we're recording this. So, kind of a relief rally across sectors, treasuries were positive for the week, mortgage-backed securities, which is that sector that we still prefer over a lot of these other core bond sectors. But high yield was positive for the week, emerging market debt. So, I mean, anywhere you were invested last week was, except for the, I think Brazil was the only area that we've shown that was negative on the week. But for the most part, it was a really good week to be invested last week.

Jeff Buchbinder (05:34):

Yeah, I guess certainly if you were in non-dollar Europe, for example, maybe you didn't do so well <laugh>, but other than investing outside of the U.S. dollar you did well, absolutely. So, as you can talk about a bit, Lawrence you know, LPL Research continues to like bonds slightly more than equities for the rest of the year. You saw that in our Midyear Outlook. But certainly we think you can get, you know, positive returns out of both between now and year end. So, let's look at the S&P as we always do, although I put a different twist on it, you know, putting on my technician hat. So, I show the S&P 500 chart on the top here, which you know, as we say, seemingly every week we've got this uptrend, higher highs, higher lows, but maybe we're a little bit overbought, at least in the short term.

Jeff Buchbinder (06:29):

On the bottom panel, I put the percentage of stocks above their 200-day moving average. This is in response to all the concern about the narrow leadership, right? And, you know, a lot of people talking about how it's just, you know, the magnificent seven, you know, the biggest seven stocks in the S&P driving most of the gains. And that's true, you know, for the year that's where we've been. But it actually is starting to broaden out. We saw it just last week with small caps doing better. We started to see performance for industrials get a little bit better, for example. And then now you see just, you know, the number of stocks that are in kind of an intermediate to long-term uptrend is rising. So, I think this, you know, counters the argument that you know, it's just a small group of stocks working.

Jeff Buchbinder (07:16):

Now on that note the NASDAQ 100 is going to be doing a rebalance next week that is actually going to move around some of the weights of some of these big tech names. I believe, according to numbers from Goldman Sachs, we're going to get about an eight-point haircut in the weighting of the mega caps in the NASDAQ 100 index. That's a pretty big haircut. They're trying to generate less concentration. So we'll see if that has any impact on those individual stocks. But certainly, that could be the start of a little bit of a pullback or, I don't know, consolidation for the big cap techs. And that actually even makes it more important that the big techs generate good earnings. So just wanted to put that out there before we get to before we get to bonds. So, Lawrence, you know, people are seeing great yields all over the bond market. You know, you've been saying that maybe it doesn't make sense to reach for yield with more risk. But yet, based on how these markets are performing, it seems like people are doing that.

Lawrence Gillum (08:32):

Yeah, I mean, your question on the previous slide was probably a bit more appropriate than the question I have on this next slide about high yield corporate credit markets. I think I'm showing this because it continues to impress me how resilient the credit markets have been this year. In light of five percent of interest rate hikes we've had regional bank crises, we've had debt ceiling debates, and yet these corporate credit markets are unfazed with everything that's going on in the market. So what we're showing here are spreads, spreads are that additional compensation for owning riskier debt above what you could earn in the treasury security. The high yield market broadly has a spread of about 3.8%. So 3.8% above treasuries. At those levels, it's in the 35th percentile, meaning spreads have been wider or more attractive 65% of the time, going back to 2000.

Lawrence Gillum (09:27):

What's even more impressive is if you look at these CCC rated credits, that's that orange line and that the spreads over Treasuries at 8%, that's in the 54th percentile over time. So again, and these CCC rated credits, these are the ones that are most prone to defaults and downgrades. And again, we're seeing this market rally like I wouldn't have expected coming into this year, giving everything that's taken place in the macro backdrop. You know, we have started to see downgrades pick up. So June was the seventh month out of the last nine where downgrades outpaced upgrades. But we're seeing defaults increase as well. So, we have about a 2% default rate. The pool of, we'll call it default eligible securities, is pretty elevated at current levels. So, we could see defaults pick up to around 4% over the next 12 months.

Lawrence Gillum (10:24):

But spreads and yields they're continue to move lower, and they continue to generate really attractive returns. Now, to your point, Jeff all in yields are still pretty attractive. So we are seeing these yield buyers, like these pension funds, these assurance insurance accounts that are just kind of clipping coupons and not really concerned about any sort of spread widening or near-term volatility. But for our tactical models, we've been staying clear of high yield. We just don't like the risk return for these high yield credits over, say, a three-to-12 month horizon. Another reason why that kind of scares me a little bit about the high yield corporate credit markets, and this is on the next slide, is that there's a lot of debt that's coming due over the next couple years.

Lawrence Gillum (11:09):

It needs to be refinanced at these higher rates. So this is what we call a maturity wall. This looks at the outstanding debt for high yield corporate issuers. And nearly 10% of the high yield universe needs to refinance its debt by 2025. So, we could see again, defaults and downgrades pick up because of these elevated rates. But for right now, markets don't care. It's been a great place to hide if you're an income-oriented investor or a total return investor. And you know, it's amazing to me how resilient the high yield corporate credit market has been, again, despite everything that's going on around it.

Jeff Buchbinder (11:49):

Yeah. It's just one more data point that maybe the bulls can point to you to say that we're going to get a soft landing, right? Or we're going to, you know, maybe hold off recession until, I don't know, late 2024 potentially, right? I mean, clearly the bond market is not telling us recessions coming, even though there are some very credible signals that are saying the opposite, right? Yield curve leading indicators, a number of things we've talked about on this podcast.

Lawrence Gillum (12:19):

It depends on where you look. Yield curve right now, given the inversion of yield curve, people would say that given the level and depth of inversion that is shouting recession is on the horizon. If you look at the corporate credit markets and the fact that spreads are in these, you know, below average levels over time, you're not getting any sort of sense of concern about any sort of recession in the near term. And you look at the fed funds future, or what the markets expect the fed funds rate to be over the next say 12 months. It's not pricing in deep cuts. And you would tend to price in deep cuts if recession was on the horizon. So, it's, yeah, we're getting different signals, but nothing that is in my view, saying that recession's right around the corner.

Jeff Buchbinder (13:03):

Yeah, it's also, you know, lending support for the argument that maybe this is a rolling recession, where we have just, you know, different segments of the economy go into recession at different times. And so when you put all those pieces together, maybe you don't have a meaningful contraction because they're out of sync, but you're still experiencing a housing recession at some point, and then you're experiencing a manufacturing recession at a later point, and then maybe a, you know, modest consumer spending recession down the road that can be offset potentially by some other factors. So, you know, that's not our house view. We wouldn't say we have conviction that that could happen, but it's certainly an argument that some, you know, really smart people are making. And, I think it's fair to say that the market is pricing that in, you know, maybe with 50/50 odds at this point, maybe even higher odds because of, you know, how high stock valuations are and frankly how low credit spreads are.

Jeff Buchbinder (14:02):

So that's something to think about as we get into earnings season, can we get enough good news to continue to push stocks higher? That's our next topic. And you know, the answer is probably nuanced. Certainly, you know, we can't say no, they won't be good enough. But I think the bar is pretty high for stocks to push another leg in this rally with, you know, valuations where we are. In fact, you know, Lawrence, I know you would say that investors aren't really getting compensated to go out on the risk curve for bonds, right? Well, we're saying that's basically the same thing for stocks. You know, if the stock valuations are very similar to bond valuations, then why would you pay extra to have that equity risk when you can get potentially similar returns out of the bond market?

Jeff Buchbinder (14:58):

So, we still have a slight preference for bonds over stocks in our tactical asset allocation, but we are fully invested in both. So, with a little less cash. So here you see the trajectory of earnings growth quarter by quarter, year over year. And you see the estimates on the right-hand side, we're expecting, based on consensus, let's say six to 7% decline in S&P 500 earnings per share. If we get the typical upside that we normally get, maybe we're looking at down four, but we're off to a pretty good start. You know, whether you look at companies that have reported early, you look at guidance, you look at estimate trends, things like that, right? We think we can maybe do a point better than that. But the ISM is quite weak. The ISM, Institute for Supply Management manufacturing index, historically, does a pretty good job of predicting the direction of earnings.

Jeff Buchbinder (15:59):

And that's pretty weak, right? I mentioned manufacturing recession, that's pretty much where we are. So, if you, you know, maybe temper your enthusiasm a little bit for earnings because of that, you know, then you're talking about three to four points of upside. But that's still not terrible because if you take out the energy sector, you're up, right? Energy is driving a significant portion of this earnings decline because of the year-over-year decline in, in energy, in oil prices and natural gas prices, frankly. So, you know, that's kind of the lay of the land. But if you look at this estimate trend, right, we're probably going to get earnings growth either in the third or fourth quarter. We'll almost certainly get it in the fourth quarter, maybe the third, call that a coin flip. And I think one of the reasons the market's been rallying is because investors and traders are anticipating that return to earnings growth.

Jeff Buchbinder (16:56):

And even though we like international equities here too, they're not in their trough just yet and we're already pretty much past it. The trough was almost certainly Q2. So, so that's kind of a moderately bullish story, I guess. The key to earnings is going to be margins, because as inflation falls, companies lose pricing power, right? And if you lose pricing power, you might not be able to preserve the margin. So, we could see some margin compression. That's something we'll be watching very closely when we hear guidance from companies. So far, it's been fine, but it's only 30 companies. It's a little too early to draw a trend. So here are estimates and then I'll let you weigh in Lawrence. So, consensus is about 218 now in S&P 500 earnings per share for 2023. We think there's a little bit of downside to that.

Jeff Buchbinder (17:48):

Maybe most of that downside comes this quarter because I mean, we're getting close enough to the end of the year. Maybe companies want to just, you know, be conservative and kind of, I don't want to say kitchen sink it, but just, you know, be a little bit conservative with the second half. It's still an uncertain economic environment. Maybe bring numbers down a little bit as companies typically do. And then by the time we get to Q3 earnings season, the year's almost over and I'm not sure how much further estimates can go from, you know, wherever they land in let's call it late August. So, it's going to be interesting to see how well estimates hold up. Again, guidance for the very few companies that have reported thus far has been pretty good, mostly. It's been some hits and misses, but it's been a little bit better than average. So that's encouraging. So, you know, if we come out of earnings season with 215 as consensus, I'll call that a win. What do you think, Lawrence?

Lawrence Gillum (18:43):

Yeah, but I think, so I think that it is an important earnings season. You know, and I'll just to put a fixed income lens on things as well that, you know, from my perspective, I'm paying attention to the amount of leverage out there, the amount of interest expense coverage ratios that are out there. So, you know, I think that the equity guys get all the, you know, the, the earnings information and that's what they pay attention to. On the fixed income side, we're more focused about can these companies continue to pay their bills, right? So, we are starting to see a slight degradation in some of these lower rated companies, call it, you know, the high yield universe as well as these BBB rated companies within the investment grade universe.

Lawrence Gillum (19:24):

So now that we're presumably past the interest rate risk for some of these markets, credit risk and the potential for downgrades and defaults is going to be more prevalent on the fixed income side. So, earnings are an important stock driver for fixed income folks like myself. It's all about cash flows and being able to pay back that debt when it's due. So that's, you know, something that may come out of this earnings season as well that we might see some weakening fundamentals on some of these lower rated companies, which again, the high yield market doesn't care right now. So, we'll have to see if that changes after this earnings season.

Jeff Buchbinder (20:00):

Yeah, you might see more of that if you go to like the Russell 2000, or at least the lower part of the Russell 1000, I guess, because obviously the biggest companies are more likely to have the stronger balance sheets. But that's a great point though that we'll be watching for you know, any sort of deterioration in fundamentals for companies. Because you know, people have been looking for more layoffs for a while. As soon as, I mean, tech kind of led the way, right, with the very high-profile layoffs at, you know, Meta and Amazon and you know, Microsoft, places like that. But it hasn't really been followed by another wave, right? So certainly, we talked about this in this week's Weekly Market Commentary which you can find on lpl.com, how you know, layoffs and cost cutting, something that we'll be listening for, hopefully certainly don't see too much in the layoff category certainly, but cost cutting could help support margins, which are really important because we're probably not going to get much revenue growth at all.

Jeff Buchbinder (21:02):

You know, part of that is because inflation's coming down but part of it is just because it's kind of a lackluster economic environment, even though, you know, most economies around the world have maybe exceeded expectations. Not China <laugh> by the way. But most economies, certainly I think Japan, U.S. and Europe have probably exceeded expectations that most would've had six months or 12 months ago. But we're still talking about a very sluggish environment, right? Including in China <laugh>, but certainly in Europe, Japan, U.S. we're talking about maybe, you know, 1% growth kind of a pace if that. So, good discussion there on earnings. Let's keep rolling. I got one. Well, I got the week ahead preview, but one more point on earnings. I showed this last week. The fact that earnings declines are more often met with stock gains <laugh> than stock declines, right?

Jeff Buchbinder (22:00):

The S&P 500 in years where earnings fall, which we're going to probably see this year, the gains actually outpace losses by like two and a half to one. So, you are much more likely to see stocks rise when earnings fall. And why is that? It's because they're forward looking. So, markets looking ahead to better earnings news ahead, certainly. So, let's get to the week ahead here, Lawrence, and talk about the economic calendar. Of course, we have a lot of earnings too that people are going to be watching closely. 60 S&P 500 companies report this week. There are some big names, mostly financials, but we certainly get some other big names outside of financials, including Netflix. So beyond earnings though, it's retail sales. I want to point out, we try to point this out every time we show the retail sales numbers.

Jeff Buchbinder (22:53):

These are nominal, right? Not inflation adjusted, but when we talk about GDP growth, we're talking about real GDP, right? Inflation adjusted, adjusted GDP. So, you know, five tenths sounds like a booming month, <laugh>, but it's really not booming when your, you know, inflation rate is maybe, you know, 20 to 30 bps that you, it's still good if we can get that kind of number, whether it's ex autos or not. These are still good numbers, they're still positive real sales growth. But I, you know, I might say that there's a little bit of downside risk here. I mean, economic data's been beating expectations consistently in the U.S. for months now. In fact, maybe we'll bring that to you next week. The economic surprise indexes that just measure basically the batting average, just economic data beat or miss economist expectations.

Jeff Buchbinder (23:48):

U.S. surprise index is surging, right? I mean, it's about as high as it gets. So maybe that would be a losing bet to say we're going to miss on retail sales. But that just seemed, you know, for all this talk, Lawrence, about consumers, you know, spending fading and, you know I guess we don't have the student loan repayments kicking in just yet, but there's a lot of reasons to think the consumer is having a bit of a tough time here, savings winding down, and yet, you know, economists see a pretty solid number here. What do you think gives?

Lawrence Gillum (24:20):

Yeah, no, I think to your point about the economic surprise index is a good one because if you look at the sub-components for a lot of these surprise indexes, it's not just one area of the economy that's surprising. It's broad based. So, either economists are too negative about the consumer, or the consumer isn't in as bad a shape as maybe we thought they were. But the consumer keeps chugging along and you know, as a father of two daughters and a wife, I know that we still get our Amazon boxes every day. So, we're helping support the economy, I think. But it's been a good story for equity markets. It's not a great story for the fixed income markets because that does tend to give the Fed more confidence that they can continue to hike rates without any sort of negative repercussions. But for equity markets, it's been a good story.

Jeff Buchbinder (25:13):

Yeah, it has. Well, I'm doing my part over here too. We've got painters painting our ceiling in our kitchen and family room today. So, you know, kicking in a little bit for the economy there after unfortunately we had a little water seep through into the ceiling. It happens, you know, <laugh>, especially with houses that aren't brand new. You've been there, I think Lawrence too, <laugh>, so it happened. So yeah, I guess the consumer keeps hanging in there. There's still some excess savings, clearly, that are still out there providing some support. I mean, there's a little bit of credit card, you know, uptick in credit card usage that we're seeing. That's helping as well. But no doubt when you have a strong job market, you know, unemployment rate at 3.6, I believe still, you've got you know, people who want a job pretty much can have one, and wages are still rising, obviously that's one of the things the Fed's worried about.

Jeff Buchbinder (26:15):

So that sets up more consumer spending gains. And maybe we just have to, I don't want to call this a bubble, but maybe we have to kind of inflate consumer spending a little bit more before we can come back down enough to actually have a contraction, a potential contraction in consumer spending, we'll see. Hope not, but that's certainly a possibility over the next, I don't know, three quarters we'll say. So, I mean, I think the only other, I mean, leading index has been in recessionary territory for a while, so I don't think that's particularly interesting. I mean, unless we get a major surprise, and it starts to tick back up again. Claims is always important these days because how tight the job market is, you know, feeds into wages and consumer spending, but particularly wages as we're worried about the Fed potentially going twice more. Our view is probably only get one, but we'll see. And then, you know, the housing data is interesting because multi-family construction helps the inflation story. I don't know if you want to make any comments, Lawrence, on the housing market, but that's been, I mean, you can see in the starts numbers, right? That's expected to come down quite a bit from the prior month. I mean, it seems to me like housing's been pretty resilient compared to expectations, especially at higher market rates.

Lawrence Gillum (27:37):

Yeah, no, that's what I was going to say. I mean, the fact that we have 7% plus mortgage rates and we're still seeing the housing market, I don't want to call it recover, but maybe be as resilient as it is, is pretty remarkable. I think I read a statistic that what 90% of mortgage mortgages have a 6% rate or lower. So, there is not a lot of movement on the mortgage side, but for those individuals that are buying houses that are taking out mortgages, it's not slowing really the mortgage market down that much or the housing market down that much.

Jeff Buchbinder (28:12):

Yeah, I guess there's not a lot of inventory maybe because some people that might move decided to just stick with their, you know, three, 4% mortgages, <laugh>, right? I mean, it sort of creates this log jam where you don't have enough sellers, even if you might have buyers. So yeah, that's something that that'll work itself off over time. But we'll have to, you know, probably get mortgage rates down. If our bond market call is, right Lawrence, we're going to have lower mortgage rates and that could help support housing, which was probably the first area to go into recession. If you buy into this rolling recession narrative, that means it's probably coming out. And if you look at the home builder stocks, you can certainly surmise that they were sniffing out the end of a housing recession and a pretty powerful recovery, because those have been big winners this year.

Lawrence Gillum (29:07):

Yes, for sure.

Jeff Buchbinder (29:09):

So anything else you want to hear?

Lawrence Gillum (29:11):

I was going to say what's not on here is important as well, that there's no Fed speak this week, thankfully. There tends to be too much Fed speak in my view. But the Fed is in their blackout period in advance of next week's meeting, which is going to be an important one. But this week it's going to be a quiet one for Fed speak, which is nice.

Jeff Buchbinder (29:32):

You know, even if I want to hear what the Fed has to say, I just find it very confusing when you hear from eight different people, <laugh>, right? Am I alone in that Lawrence or does everybody?

Lawrence Gillum (29:44):

No, I get the reason why. There was a lack of communication during the Alan Greenspan days, and they wanted to make it more transparent. So, Bernanke and Yellen, they all wanted to make it more transparent. It's gotten too transparent. You're deliberating your ideas in public, and a lot of your ideas and your thoughts are not consistent with the broader FOMC at times. So, it does get confusing, and it leads to more volatile market FOMC out there talking their views every day. And that's my soapbox.

Jeff Buchbinder (30:24):

So, I'm not crazy. I'm actually probably in the majority out there who, for those of you who follow all these Fed speakers, if you're confused a little bit at times, that's okay. Lawrence said so, that's okay. <Laugh> great. So, it'll be really interesting to hear what the Fed has to say next week. Certainly, we'll talk about that on the podcast in a week because we have the next Fed meeting on July 25th and 26th. And man, July's flying by, we're already more than halfway done. So always enjoy the Fed meetings and hear sometimes obviously markets react negatively, but I always find the Fed meetings very interesting even though I often say that I don't need to hear from all the Fed speakers. So, let's go ahead and wrap on that cheery note <laugh>. So, thanks everybody for joining. Thanks Lawrence, for jumping on and, you know, putting some fixed income with my equities and making a balanced podcast. Everybody have a great day. Thank you, and we will talk to you next time. <Silence>.