GDP Surprise Strength


Positive news from the GDP and Tesla … are earnings forecasts delusional? … weakening consumer health … all eyes on next Wednesday

Score one for the “soft landing” narrative.This morning, we learned that Q4 GDP topped estimates, climbing at a 2.9% annualized pace, compared to the expectation of 2.8%.Consumer spending, accounting for roughly 68% of the entire GDP reading, increased 2.1%. While that’s down from 2.3% in the previous period, it still reflects a U.S. consumer who’s not afraid to spend.As I write Thursday morning, the market has the added boost of an earnings beat from Tesla, combined with some upbeat forward-looking commentary from CEO Elon Musk.The bulls have been throwing their weight around in recent weeks, and on top of this strong news, we have to ask – is the bear market over?Perhaps, I don’t have a crystal ball. But I remain cautious based on a murky/conflicting 2023 outlook at best.For example, look at IBM’s earnings release this morning…We learned that revenue surged more than 6% in 2022. That’s the biggest sales increase for the company in more than a decade.But we also learned the company is laying off nearly 4,000 employees.So, which data point will you focus on? The solid revenue growth of the past, or the downbeat slashed headcount of the future?In the same way, investors have a similar decision to make about broader economic data – focus on bullish or bearish numbers? You have your choice of both.In recent weeks, the bullish interpretation has won the day. Microsoft was a good example yesterday.The tech giant offered a pessimistic outlook about coming economic conditions, resulting in a 4%+ selloff in the morning…but Wall shrugged it off and the stock regained nearly all of its morning losses by the end of the day.

We continue to be cautious about this recent rally based on the likelihood of weaker-than-expected earnings in the months to come

Yes, some Wall Street analysts have finally been lowering their earnings forecasts, but we question whether it’s enough to match the economic tightness that’s on the way.Here’s an illustration…In our Monday Digest, we highlighted a research report from Morgan Stanley that pointed toward the artificially high condition of earnings and margins since 2020 thanks to Federal stimulus money.From Morgan Stanley:

[Investors] seem to be overlooking how the largest stimulus program in U.S. history, precipitated by the pandemic, has kept current profit margins and demand levels running above long-term trends. For example:

  • The operating margin of the S&P 500 Index, at 11.6%, is still near the all-time high of 13.1% reached in late 2021—notably above pre-pandemic levels of 10.2% and the rolling 10-year average of 9.4%.
  • 2022 nominal revenues for S&P 500 companies were 8% above the 10-year trend.
  • Last year’s real, or inflation-adjusted, consumption was about 7% above its long-run trend.

Now, with this in mind, let’s turn to FactSet, which is the go-to earnings data analytics company used by the pros.From their most recent Earnings Insights report (emphasis added):

…Companies are facing a difficult year-over-year comparison to unusually high net profit margins in 2021.In Q4 2021, the S&P 500 recorded the fourth-highest net profit margin (12.4%) reported by the index since FactSet began tracking this metric in 2008.It is interesting to note that analysts believe net profit margins for the S&P 500 will be higher going forward.As of today, the estimated net profit margins for Q1 2023, Q2 2023, Q3 2023, and Q4 2023 are 11.9%, 12.1%, 12.3%, and 12.2%, respectively.

How does that make sense?We’re coming out of a period of artificially-enhanced profit margins, thanks to the anomaly of Federal stimulus money… we’re headed into an economic slowdown at best, recession at worst… and yet some analysts believe profit margins are headed higher?

In case I’m the one who’s too pessimistic, let’s check in on the condition of the U.S. shopper

Even though the GDP report this morning showed consumer spending grew 2.1%, the trajectory is “down.”What other data do we have that gives us a reading on U.S. shoppers?Well, the latest retail spending report comes from December.Here’s The Wall Street Journal with how it fared:

Retail spending fell in December at the sharpest pace of 2022, marking a dismal end to the holiday shopping season as rising interest rates, still-high inflation and concerns about a slowing economy pinched American consumers.

And here’s an interesting update from Tuesday’s Wall Street Journal:

Americans are cutting back on many everyday purchases amid inflation, while splurging on a few big-ticket items…After more than a year of high inflation, consumers are exhausted from the dozens of budgeting micro-decisions they must make in a given day, economists say. And yet, some with at least a little wiggle room in their budgets are deciding to splurge on trips, experiences and designer products while drastically cutting back elsewhere…Economists call this an attempt to reclaim agency over their finances…“You become so overwhelmed with trying to squeeze where you can, you just break,” says Kelly Taylor, who owns a small public-relations company in Los Angeles. “You’re like, ‘Screw this, I’m going to Mexico.’”

Maybe it’s just me, but being so overwhelmed financially that you eventually “break” and conclude “screw this, I’m going to Mexico” does not sound like an economic climate ripe for expanding profit margins.But maybe I’m missing something. After all, think of how much profit padding corporate America will enjoy thanks to its slashed employee headcount.(While ignoring the inability of those fired employees to keep spending in the economy.)

On that note, on Tuesday, we learned that in the last five months of 2022, employers cut the most jobs since early 2021

From the WSJ:

Employers are shedding temporary workers at a fast rate, a sign that broader job losses could be on the horizon. In the last five months of 2022, employers cut 110,800 temp workers, including 35,000 in December, the largest monthly drop since early 2021.Many economists view the sector as an early indicator of future labor-market shifts. Temporary employment declined before some recent recessions and during economic slowdowns. 

That doesn’t sound great, but how are U.S. businesses in general holding up?From Bloomberg on Tuesday:

US business activity contracted for a seventh month, though at a more moderate pace, while a measure of input prices firmed in a sign of lingering inflationary pressures.The S&P Global flash January composite purchasing managers index rose 1.6 points to 46.6, the group reported Tuesday. Readings below 50 indicate falling activity.The gauge of input prices climbed for the first time since May.

So, on one hand, U.S. business activity didn’t contract as much compared to the previous seven months.On the other hand, inflation – which is supposedly conquered – turned back north.From Chris Williamson, Chief Business Economist at S&P Global Market Intelligence:

The worry is that, not only has the survey indicated a downturn in economic activity at the start of the year, but the rate of input cost inflation has accelerated into the new year, linked in part to upward wage pressures, which could encourage a further aggressive tightening of Fed policy despite rising recession risks.

To be clear, I’m not trying to make the case for a recession, or more aggressive tightening from the Fed.All I’m saying is “given everything we’ve just looked at, it seems unlikely that net profit margins are going to head higher this year.”This is important because the more that Wall Street believes margins will expand – and prices that expansion into the market – the bigger the eventual market selloff if/when earnings fail to live up to those expectations.Speaking of “what Wall Street believes,” let’s turn to the Fed…

What will we see next Wednesday?

As we’ve chronicled numerous times here in the Digest, there’s an enormous disconnect between what the Fed tells us it is likely to do with its interest rate policy in 2023 and what Wall Street believes will actually happen.In short, even though the Fed says to prepare for a terminal rate above 5%, which it will hold for all of 2023, Wall Street doesn’t buy it.Instead, Wall Street expects impending dovishness, followed by rate-cuts later this year. And so, Wall Street has been pushing up prices in anticipation of that happy outcome.Here’s Barron’s:

The risk is that investors are getting ahead of themselves.Officials from the Fed have cautioned in remarks this year that tackling inflation remains a priority and that rates are likely to go higher.You can’t fight the Fed. The central bank will always win.If investors are ahead of themselves, the Fed won’t catch up—investors will fall back.“The gap between the market and Fed right now is huge,” said Neil Wilson, an analyst at“Garbage is leading the rally…I don’t think that the market is reading this right. The macro is broken.”

Of course, Wilson could be wrong. Wall Street could be right. The Fed could surprise us all with a wonderfully dovish new persona.In any case, all eyes are on next Wednesday for clues. That’s when the Fed releases its latest policy statement and we hear from Fed Chairman Jerome Powell.Will the Fed continue with its hawkish rhetoric, or will it soften?And if it maintains its hawkishness, will Wall Street continue to brush it off?We’ll continue to keep you up to date in the Digest.Have a good evening,Jeff Remsburg

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