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Earnings squeeze heralds winter freeze on Wall Street: McGeever

Investors can’t say they’ve not been warned.

The number of red flags raised by U.S. firms for the earnings outlook suggests Wall Street faces icy headwinds this winter, as rising borrowing costs and mortgage rates hit households and the rampant dollar squeezes overseas profits.

Corporate earnings growth forecasts have fallen recently but there is more to go. Once this is fully factored into equity prices, the S&P 500’s current rebound may prove to be nothing more than a classic bear market rally.

Full-year S&P 500 earnings growth forecasts have been slashed to 4.5% on aggregate from over 11% three months ago. The IBES weighted 12-month forward earnings growth estimate has fallen to a 2022 low of 7.2% from almost 10% in the summer.

But these numbers are only really starting to come down now and will likely decline further in the coming months, paving the way for an earnings ‘recession’. This will replace the Fed’s aggressive rate-hiking campaign as the main market driver.

“I don’t believe the downward revisions are done yet. There’s still a ways to go, and that will be the next leg down for equities,” reckons Ryan Nauman, market strategist at Zephyr.

At the market high in January, the S&P 500’s 12-month forward price-to-earnings ratio was over 21.0. It is now just below 16.0, but that is still only around long-term averages.

The problem for investors is an earnings decline on its own mechanically pushes up the PE ratio, making stocks more expensive. This suggests the price component needs to fall to lower the multiple and make stocks more attractive to buyers.

The S&P 500 index earnings are currently around $235. Analysts at Citi expect that to fall to $221 by the end of this year and $215 next year, or even lower if recession hits hard.

The first tremors came in July when Walmart issued a profit warning. Since then, FedEx withdrew earnings guidance, Nike warned of a margins squeeze from high inventories; Apple said it will not boost iPhone 14 production due to sluggish demand; and on Tuesday Hasbro cut its revenue forecasts.

The common thread going into the peak retail season with the Thanksgiving and Christmas holidays is that consumer spending is likely to be lower than firms had hoped.

S&P Global Market Intelligence research shows that the ‘consumer discretionary’ sector, which is highly sensitive to the economic cycle, is becoming the riskiest on Wall Street.

It has recorded the sharpest increase in the share of firms lowering corporate guidance this year. The number of companies that did so in the third quarter more than doubled from the second quarter, and was 10 times higher than the first.

THROW IN THE TOWEL?

The challenges facing U.S. consumers are growing in number and severity.

Mortgage rates have reached 7%, the highest since 2008 and a major blow to first-time buyers and homeowners switching to new rates. The reverse wealth effect is already beginning to play out as housing market activity slows.

Inflation is easing but it remains sticky, and higher than average wage growth. Workers’ disposable income is being squeezed, just as cracks are starting to appear in the labor market.

On top of that, the dollar’s appreciation is bad news for U.S. corporate profits. Around a third of S&P 500 companies’ sales are overseas, and the dollar is up 16% so far this year, on course for its biggest annual gain in 50 years.

Mike Wilson, head of U.S. equity strategy at Morgan Stanley, says that, all else equal, the exchange rate is effectively a 10% headwind to fourth-quarter S&P 500 earnings per share.

In this light, it is hard to see how the historic corporate profit margins in the April-June period will be repeated in the second half of the year.

Wilson has been one of the most bearish – and accurate – analysts on Wall Street this year. He agrees that the darkening earnings picture has played second fiddle to the Fed this year, but not for much longer.

“Companies are loathe to throw in the towel on future quarters until they have to. It appears that more are reaching that point where they can’t fight it anymore,” he and his team wrote on Monday.

They point to the equity and bond market dynamics on the last day of the third quarter, and the S&P 500’s previous low on June 16.

The index’s forward EPS and PE ratio slipped 1% to $236 and 15.2, respectively. Meanwhile, 10-year nominal and real yields soared more than 60 and 100 basis points, respectively, and the equity risk premium fell more than 50 bps.

Basically, the slump in stocks from mid-August was led by rates rather than a major shift in the earnings outlook. With the implied Fed terminal rate unlikely to get much above the September high around 4.80%, that won’t be the case from here.
Source: Reuters (By Jamie McGeever; Editing by Andrea Ricci)

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