Earnings Season Takeaways: The Implications For Markets And The Economy

While the possibility of peak inflation may be a positive for markets, the outlook for earnings may temper that enthusiasm somewhat. Greg Bonnell speaks with Damian Fernandes, Portfolio Manager at TD Asset Management, about the latest earnings takeaways and the implications for investors.

Greg Bonnell: One of the trends we’ve seen this earnings season is layoffs and growth warnings from big tech names. But should that worry investors about where the broader markets are headed? Joining us now to discuss, Damian Fernandes, portfolio manager with TD Asset Management. Damian, great to have you back on the show.

Damian Fernandes: Pleasure as always, Greg.

Greg Bonnell: So this is the earnings season where people are saying, OK, brace yourselves. We’re going to hear from the big corporate leaders. They’re going to opine on the economy, the state of everything. We’ve heard about layoffs. What should we be thinking about it?

Damian Fernandes: I’ve actually just– I was reflecting, Greg, the last time I was on the show was for earnings season. And I feel the trend here, a consistency, at least, to dissect earnings. The last time I was on the show, if you recall, was Q3 earnings. And the questions then were, how bad is it going to get? Is it — were we going to have positive earnings? We’re in the thick of Q4 earnings now, and they’re bad.

The market isn’t collapsing. I’ll put some numbers to it, right? 70% of US companies by market cap have reported. The top line is growing about 5.5%. So think in line with inflation.

But earnings per share are down about six. So you’ve had a massive spread, right? 5 minus 6. That spread is margin degradation across the board. And when I think about it, we’re far enough in earnings season right now that you can probably draw some inferences.

The biggest sectors of the US market, whether it be communications services, Google, Facebook; consumer discretionary, Amazon, Tesla; information technology, Microsoft, Apple, these bellwether stocks, all of those stocks have registered earnings declines — double-digit earnings declines depending — some even much worse. So I think that’s what’s really — the reason earnings have taken a step down, and earnings are negative, and that likely to continue for the rest of the year is because the stocks that were previously helping pull up the earnings — the earnings number are now facing some real headwinds.

Greg Bonnell: Ok, so let’s talk about some of the announcements we’ve heard. Obviously, in tech, it’s almost become pretty routine. I’m not surprised when I log in in the morning. It’ll say, oh, Dell is cutting jobs, and they’re on the heels of all these other companies.

What does that tell us? Some people will say, well, uh-oh, here it comes for the broader economy. But then you get the jobs report, and you start to wonder, how do I square the two?

Damian Fernandes: Yeah, it’s– so Dell yesterday saying 5% of the workforce, I think, if memory serves me, and a slew of different announcements. I think about this in two ways. Let’s talk about the economy first. And let’s then talk about it in terms of the companies.

In terms of the economy, I totaled it up the other day, just the announcements, the public announcements so far. And there were about 12,000 jobs– sorry, not 12,000 jobs– 91,000 jobs that have been announced. Google was 12. It’s back of my head.

But 91,000 jobs when last Friday the jobs report was over 500, right? So just to put that in perspective, yes. And by the way, these jobs aren’t immediate, right? There’s severance. There’s multiple quarters.

So these jobs are going to– you’ll see attrition over time. But we just had a half a million jobs announced on Friday. So I think the economy is– structurally, broad-based is doing fine. You’re seeing pockets of weakness.

We’re not seeing evidence of whether those displacements in the technology sector that you’re seeing right now are moving, are infecting other sectors, right? The jobs number on Friday was broad-based. It was health — it was health care. It was education. It was services. We’re not seeing that yet. When I think about the companies, though, I think this is probably a good thing, right? Because a lot of these technology companies were spending and hiring at will because they believed the pandemic– the pandemic, really– what happened in the pandemic was that these revenues of these tech companies, they were the only game in town, whether it was Amazon or [INAUDIBLE].

Greg Bonnell: Yeah, it changed their lives. But I think they bet that it would change our lives forever, and we could never go back.

Damian Fernandes: Yeah, exactly. I think that they thought it was the permanence of that. So they obviously overhired, overspent, and now they’re retrenching. And they still are very profitable companies. So that’s why, I think, in your opening remarks, it said Microsoft up on the day. Microsoft’s been up since earnings. It’s been up since earnings, and earnings were negative. And I think there’s information in that that the company– the investor base is seeing the actual changes the company is making to reduce the cost base to get back to that positive earnings trajectory.

Greg Bonnell: Considering what we’ve been through and considering what we’re hearing this earnings season, what should we be thinking, as investors, about earnings longer term?

Damian Fernandes: So this year, most definitely, we are likely that we’re going to have an earnings recession. It’s a question mark if we have a recession, per se, an economic recession or a soft landing. Full disclosure, I hate the term soft landing. Nothing’s soft about you losing your job or a downtrend in consumption. But likely, given the pace and magnitude of rate hikes that have already been announced that are– we probably have one or two more coming down– that is going to weigh on economic activity, which means growth is going to slow. Earnings, so far negative, are going to continue.

But when I think about earnings going forward, it’s, what is the trend rate not for earnings in 2023, but for the year we’re in, but 2024? Are earnings in 2024 going to be higher than earnings in 2022? Let’s call this year the pivot year or the transition year.And I think that’s where the market– right now, the market multiple is elevated, but it’s elevated on this year’s earnings. On next year’s earnings, there’s still– there’s as much positives as negatives that I’m looking at. And right now, I don’t think you can make any strong inferences either way.

Greg Bonnell: Because the market supposed to be a forward looking instrument.

Damian Fernandes: Exactly.

Greg Bonnell: It’s not supposed to tell us about what we’re living through right now because we know. It’s supposed to be looking ahead to what it expects out of these companies going forward.

Damian Fernandes: Historically, when you look at the data– and I don’t like calendar-izing years– but in years where– because the market doesn’t care about Jan 1 and December 31, right? But if you look at historical data, in negative earnings years, more likely than not, the market’s up. The years– there’s been a few examples, or, I guess, a few years where that hasn’t held. It’s 2001, 2008, 1990.All of those areas, if memory serves– if memory serves me, are pivotal, right? ’01, tech collapse, collapse in earnings, negative markets. ’08, the trauma associated with the financial crisis. 1990, for those with longer memories, was the savings and loan crisis. But every other time the market has had negative earnings, it’s actually been positive, right? We were positive in Jan, so it might be flat for the year.

I just like– I don’t think– when you hear about negative earnings, the immediate reaction is like, oh my god. This is a devastating thing, but last year, we had positive earnings and negative markets because it’s, to your point, forward-looking.

Greg Bonnell: Let’s talk a little bit about– I’m not going to use the term that you don’t like, but if you do get inflation coming back to where the central banks want to see it, you don’t do too much damage to the economy or the labor market, you get that Goldilocks scenario, what parts of the market might work in an environment like that?

Damian Fernandes: Yeah, we ought to find an adjective for soft that’s a similar– supple.

Greg Bonnell: Non-hard landing.

Damian Fernandes: Non-hard landing.

Greg Bonnell: Non-hard landing.

Damian Fernandes: Benign. So the areas of the marketplace we are most interested in to this day continue to be– our process is identifying dislocations in cash flow generation, right? When you think about the marketplace, people assume the marketplace is just– you talked about Powell’s coming up. It’s going to be beholden to the whims of Powell, or what’s happening in China, or geopolitical stuff.

Ultimately, the marketplace is a collection of cash flows, and where we can trade values, finding companies where those cash flows are misunderstood. And the fastest areas of cash flow production in the market continue to be in areas not like tech, which is seeing a downshift. Hopefully, those expense cuts will lead to faster, higher free cash regeneration. But in areas like, to a certain degree, oil and gas, financial.

In our– let’s– in our not hard landing scenario, the tip of the spear is going to be financials because they’ll still– if you’re not in a hard landing, the Fed probably doesn’t have to cut rates aggressively. They still benefit from net interest margin. Credit costs are probably a little less bad than forecasted, so revenues will be higher. And the US banks are already still buying back shares and paying you north of a 3% divvy. So that, to me, is good optionality, right? A good skew if you don’t have a very dramatic economic outcome.

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