Cooling Inflation Implications, Midterm Musings, 3Q22 Reporting Season Update Transcript

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Welcome to RBC’s Markets in Motion podcast recorded November 15th, 2022. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers. Today in the podcast, we reflect on hot topics and some of the most interesting things we saw and heard last week. Three big things you need to know: First, we generally see last week’s cooler-than-expected inflation print as constructive for US equities, with some caveats. Second, while we see the anticipated outcome of the midterm elections as supportive of stocks, we find that we’re less excited than some as we think a divided government has been getting baked in since the mid-October lows and worry that any incremental upside in 4Q will borrow against 2023’s gains. Third, 3Q22 reporting season has revealed a softening of the earnings backdrop, with the best trends in Energy and Small Cap.

If you’d like to hear more, here’s another 10 minutes – we’re a little longer than usual this week as the podcast will be taking a break next week for Thanksgiving. As always, while you’re waiting a quick reminder that you can subscribe to this podcast on Apple, Spotify and other major platforms.

Now, the details.

Starting with Takeaway #1: We generally see last week’s cooler than expected CPI print as constructive for US equities, with some caveats.

  • What we like is that the deceleration in inflation that many equity investors have been expecting and hoping for finally materialized. In our view, the chances have improved a bit that the Fed will end hikes sooner rather than later (our house view is for the last hike in March) and that a short shallow, near-term recession, rather than a deeper/longer-term one, will occur.
  • One thing we don’t like is that the S&P 500 has lost its valuation appeal again. Following last week’s bounce, S&P 500 P/Es are near average on consensus EPS and a bit above average on RBC’s EPS forecasts – not frothy but lacking the appeal we had started to see around the October lows.
  • We also don’t like the potential for hawkish Fed rhetoric to make a comeback to keep financial conditions from getting too loose. We’ve already gotten a flavor of that from Waller. More hawkish rhetoric, even in the context of a debate between hawks and doves, likely adds to stock market volatility in the months ahead.
  • What moderating inflation means for US equities broadly is a complicated affair, given that inflation expectations are still generally elevated relative to history despite coming down a bit.
  • The main thing we’ve been communicating to investors on this point lately is that moderating inflation is a headwind for S&P 500 EPS due to its correlation with revenues, but should still allow for some modest P/E expansion in the year ahead based on our analysis of the relationship between interest rates, inflation, and S&P 500 P/Es dating back to the 1970s. Just at levels below what they’ve become accustomed to in recent years.
  • Similarly, positioning in US equities in US households seems likely to come under pressure as inflation moderates, but a higher-than-expected run rate may provide something of a buffer. On page 6, we highlight how US equities as a percent of total financial assets (net of cash and bonds) tend to track CPI. Moderating inflation seems likely to be accompanied by lower US equity exposure, but higher levels of inflation relative to recent history may serve to prop that positioning up if that is what ends up occurring.

Moving on to Takeaway #2: We see the midterm results ass good for stocks, but we’re just not as excited as everyone else seems to be.

  • As of Tuesday morning, the Senate was projected to stay under Democratic control. House control had not yet been called though the Republicans still appeared to have a slight edge there. NBC News was projecting that Republicans would win 220 House seats vs. 215 for Democrats. Although Republicans underperformed expectations and got a red ripple rather than a red wave, for now the market still appears to have gotten the divided government it wanted.
  • What does this mean for stocks going forward in the near term? If Republicans don’t end up taking the House, we see it as a negative stock market event in the short term.
  • And if the House does go to the Republicans as anticipated, we think a lot of it may be baked in already. In our view, the stock market has been baking in the return of a divided government since the mid-October 2022 low in the S&P 500, which occurred right in line with where the index historically bottoms, on average, before a midterm election day. Additionally, the move seen in the stock market since the mid-October 2022 low has exceeded the typical midterm bounce already.

To be fair, there is some precedence for the stock market to move up a bit more than it has already in midterm election years. As we’ve highlighted before, 2022 has been tracking 2002 rather closely, and that year the S&P 500 experienced a 21% bounce off of its pre-midterm low before topping out in November. But If that happens this time around, we think it will probably be something other than confirmation of a narrow majority in the House that will take the stock market there. Republicans winning both chambers could have caused that kind of reaction in the S&P 500, but that didn’t materialize.

  • Longer term (i.e., into 2023), we see the results of the midterms as supportive of the stock market. The S&P 500 has risen 14% on average under a Democratic President and split Congress. Further spending packages seem unlikely which could be seen by market participants as adding to the United States’ inflation problem.
  • And dating back to the 1970s, the S&P 500 has tended to post gains in the 4thquarter of midterm election years as well as the following calendar year.
  • But we also find ourselves thinking that the bullish narrative on the longer-term implications has been a little oversimplified and overstated in recent days. In our investor meetings last week, one thing that we kept pointing out was that in three of the past four midterm election years, the stock market has rallied in the fourth quarter but has only seen flattish/mildly positive returns the following year. The more the stock market rallies after this midterm in the fourth quarter, the more we will worry that investors are borrowing against 2023’s potential gains.

Wrapping up with takeaway #3 on 3Q22 reporting season. The earnings backdrop is softening, though the sharp cuts investors have wanted still haven’t materialized, with relative strength in Energy and Small Caps, and relative weakness in Communication Services.

  • With 91% of S&P 500 and 61% of Russell 2000 results in as of last Thursday, here are the stats jumping out to us at the moment:
  • 70% of S&P 500 companies are beating consensus EPS and sales, weaker than recent quarters. Small Caps are not quite as strong as Large Cap (60% are beating on EPS, 63% on revenue) but have a better trend as their stats are stable vs. past quarters.
  • We are seeing mostly downward revisions for both the S&P 500 and Russell 2000 right now. But we are still seeing slightly more upward revisions in Small Cap than Large Cap, helping explain why Small Caps have started to outperform Large Caps recently.
  • While we still think 2023 numbers need to come down for the S&P 500, keeping stocks volatile, the good news is that stocks tend to bottom 3-6 months before EPS revisions stop falling.
  • Bottom-up 2023 consensus S&P 500 EPS has inched lower by another $1 this past week to $232, still well above our own forecast of $208. Beneath the surface, EPS and revenue growth forecasts have been moving up for 3Q22 and down for 4Q22, but margin forecasts are down for both 3Q22 and 4Q22.
  • At the sector level, Energy is seeing the most EPS beats in the S&P 500, while Technology is seeing the most EPS beats in the Russell 2000. Communication Services and Materials beat rates are low vs. other sectors in both indices.
  • Within the R1000, EPS beats have been rewarded the most in Materials and Industrials, while misses have been punished most in Communication Services and Technology.
  • Within the R2000, EPS beats have been most rewarded in Financials and Energy, while misses have been hit hardest in Communication Services and Technology.
  • When looking at earnings sentiment, no sector is seeing mostly positive revisions right now on EPS in either the S&P 500 or the Russell 2000, though a few are still seeing positive revenue revisions including Utilities and REITs in the S&P 500 and Energy, Financials and Utilities in the R2000.
  • In percentage terms, 2023 EPS, revenue, and margin forecasts have been coming down for most S&P 500 sectors.
  • For 3Q22, trends have been mixed by sector on EPS and revenue forecasts, with Consumer Staples, Energy, Health Care, and Utilities all moving up a little on both.

That’s all for now. Thanks for listening. And be sure to check out RBC’s new macro podcast, Macro Minutes, for thoughts from RBC’s team of strategists and analysts in rates, economics, FX, equities and other areas.