Markets were mixed yesterday with the NASDAQ stocks the weakest. After the close, Netflix reported results that disappointed investors sending its shares down 6% in overnight trading and setting the tone for more angst today. This morning, Dow component Procter & Gamble reported better than expected earnings on weaker than expected sales. It warned of a future headwind from a strong dollar. Its shares are trading flat in pre-market trading.
Overnight, Israel responded to last Saturday’s attack from Iran. But it was a measured response that appeared designed to make a statement without escalating conflicts. Markets remain on edge. Oil prices actually fell, perhaps in part a sigh of relief that fears of a large-scale escalation are reduced.
Fridays and Mondays aren’t big days during earnings season. The real surge in reporting will begin next Tuesday and will continue through the following week. The big names that saw strong first quarter surges in their stock prices have high bars facing them. Most will have to meet and exceed even whisper numbers to advance further. There are caution flags. As noted above in today’s P&G report, the strengthening dollar, particularly against Asian currencies, will be a growing headwind over the next few quarters. The surge in capital spending relative to artificial intelligence (AI) is starting to become a real constraint on growth. Taiwan Semiconductor, the largest producer of AI chips for the semiconductor industry, expects at least a 25% increase in its electricity costs. Companies must relocate data centers due to expected electricity shortages. The problems are not only electric capacity, but the transmission grid. Both appear undersized today to meet tomorrow’s needs. The solutions are obvious but they need to align with government green initiatives. Permitting and other regulatory constraints are likely to provide limits and, in some cases, actual shortages of power that will require seasonal brownouts. And I haven’t mentioned the future need to support the growth of electric vehicle production. These problems aren’t insurmountable, but especially when governments are involved, they often can take longer to solve, providing constraints to growth in the meantime.
Yesterday, a regional Fed President warned that it was possible there will be no Fed Funds rate cut this year. That’s true, it’s possible. But don’t overread that. Just weeks ago, Fed Chair Jerome Powell hinted that the first cut was likely in June. Now that is unlikely. Listening to any economist telling you what might or might not happen between now and the fall is a waste of time. There are lots of reasons to expect inflationary pressures to continue to recede. And there are nearly as many reasons why the path toward 2% will be longer than expected. Tell me Q3 GDP growth, the level of employment, the number of new immigrants over the balance of this year, the value of the dollar, the price of oil on Labor Day, and the impact of a hot (or not-so-hot) summer, and I will tell you what the Fed Funds rate will be. Except, obviously, you can’t give me all the data thus making any forecast today a pure guess. The real focus for investors shouldn’t be about the Fed Funds rate. Assuming long-term inflation expectations are well anchored as they should be with relatively restrictive monetary policy, the key this year will be all about earnings.
Forecasts at the moment are rather diverse. An expected soft landing has raised forecasts with the consensus now showing growth approaching 10%. Growth next year is expected to be closer to 15%. But imbedded in those numbers are a lot of factors that may or may not pan out. First, those forecasts presume no recession. The odds of one have come down in recent months, but the inverted yield curve and other warning signs suggest the odds of recession are still above average. If rates in the U.S. stay higher for longer while central banks around the world start to cut rates, the dollar could get even stronger. That would be a headwind to earnings. Finally, earnings growth won’t be even sector by sector. Tech will logically continue to lead followed by the build out of infrastructure to support the growth of AI, the reshoring of production, and an overall upgrade to our nation’s deteriorating infrastructure. However, at the same time, it is evident that lower income segments of our economy are being pinched today by higher rates. They have reached their borrowing limits and have to constrain spending. It isn’t fully apparent at retail yet but rising credit balances and default rates indicate the impact isn’t far off.
As a reminder as we enter the heart of earnings season, if one excludes the Magnificent 7, revenue growth for the rest of the S&P 500 in the fourth quarter was just 3%, pretty much in line with GDP growth. Profits fell as margins were squeezed. Getting toward 10% growth this year requires an acceleration in revenue growth and some improvement in margins. I remain less optimistic than consensus. Management comments associated with first quarter earnings reports will go a long way to either bring me up to consensus or tone down the market’s optimism.
Today, Kate Hudson is 45. Iran’s Supreme Leader Ali Hosseini Khamenei turns 85.
James M. Meyer, CFA 610-260-2220