Transcript
Brian Foerster: This is Brian Foerster, and welcome to the Active Investor Podcast, part of Lord Abbett's investment conversation series. In this podcast, we look at what we think are some of the most relevant, near term and longer-term drivers in the equity market. So, thinking about investor behavior, risk factors, how changing market dynamics tend to influence stock prices, and really where some of the big megatrends are building.
And in today's episode, we're going to be looking at both the very near term, so getting under the hood of the most recent earnings data. And then also thinking longer term about where corporate earnings may be headed the rest of this year and then into 2023.
And for this episode, we are having not one but two investment strategists on this podcast. I guess just having me alone here would not be sufficient. So my colleague, Melanie Coffin, who is our resident expert on dissecting earnings and helping investors make sense of what's driving the equity markets-- she's here with me.
And we recently put out a Market View paper on earnings that can be found on LordAbbett.com that kind of is the driver of this discussion today. So first, let me just welcome Melanie Coffin here to this podcast. And a quick background on Melanie.
She has worked at Lord Abbett since 2018, and prior to that worked in the financial technology industry. So she really knows her stuff on things like earnings analytics, equity markets, and what the data is telling us. She has an economics degree from Lafayette, and she's a CFA charter holder, as well as a holder of the CFA ESG certification. So Melanie, thanks for being here.
Melanie Coffin: Thank you so much for having me today, Brian.
Foerster: So again, we're going to focus on earnings and what we just saw from Q2, as well as what we're expecting in the quarters ahead with all that's happening today around inflation, rates-- recession fears, the ongoing tech revolution and all the disruption going on there, I don't know, Midterms, war in Europe. There's a lot.
It's enough to send equities into a bear market, which I guess is kind of what we've seen already. But then again, the piece that you and I wrote did highlight some optimistic data points. And we noted, even in the title of the piece that there may be some signs of a market bottom forming, which certainly would be welcome news after the year we've seen so far.
And so I thought we'd kind of start at the macro level and then work our way down to the micro level, which is kind of really where you start to see the opportunity-- for active management. So if we start with the macro—inflation--we saw some misses during the quarter. It also caused the Fed to continue to be aggressive-- with what they're doing. So, Melanie, how should investors be thinking about earnings given this macro backdrop?
Coffin: I think that's a good place to start. And I think it makes sense if we take a step back. So as earnings were coming in through July and August, what we saw were that the winners were really getting a big boost. And then those that missed from an earnings perspective were really not getting punished at all.
And I think this marks-- a pretty notable departure from what we have seen in the prior few quarters where it was a much more punitive environment, particularly for those stocks that were missing from the earnings side of things.
And when we take a step back, I think this can largely be attributed to a somewhat favorable environment, because on aggregate, earnings came in better than feared. Now if we fast forward to [the monetary policy conference at] Jackson Hole at the end of August, [U.S. Federal Reserve Board Chairman Jerome] Powell came out and really underscored the Fed's commitment to combatting inflation.
He upgraded his view from moderately restrictive to restrictive for some time. And then also suggested that that lower-than-expected July CPI report was simply not enough to take 75 basis points off the table in September. So following the conference, what I would expect to see is that we're going to be in this more restrictive policy stance for some time.
And that's simply because in the Fed's eyes, the progress on inflation has simply fallen short of what they would like to see. And so the bigger picture is that, following Jackson Hole, it really took the wind out of the sails for equity markets.
And at the same time, it marked this bifurcation in how the market was responding to earnings data. So before Jackson Hole, pre Jackson Hole, I mentioned that it was a less punitive environment. Companies that were beating expectations were getting rewarded.
Companies that were coming in lower than what the street anticipated were really not being punished. After Jackson Hole, this marked a significant reversal where the market really didn't have much tolerance at all for even good news.
And bad news was punished harshly, reverting to that environment that we saw in the beginning of 2022. And you can even see this if you look at how the index has performed. Looking at the S&P 500 since August 26th through yesterday's close, the market's down just under 4%.
And I think this really speaks to the shift that we're seeing in market sentiment. So at a high level, coming into this earnings season, it was really a push and pull between two narratives: One which was a little bit more optimistic hoping that the worst was being us, and then the other one recognizing that the Fed is going to be restrictive for longer. And it seems like at this point, most of the market is really falling in that latter camp, which has certainly weighed on equities over the last two or so weeks.
Foerster: Yeah. So you've just definitely seen-- a big shift since Jackson Hole. And it's almost like, in the pre-period-- there was this optimism that we'd seen, the worst was behind us, and that these earnings were perhaps sustainable.
And that a lot of the worst fears were behind us. And now it's kind of, like, well, the earnings were better than we thought, but they're still, maybe they're not there-- as sustainable. We'll get to that in a minute. I guess the next question is, can you dive a little bit more deeply into some of the themes from a sector and market cap perspective?
And I think I'll just note that I think we're going to touch on some individual names here. And I think no one-- nobody should read our discussion of these names one way or the other. We're really just noting them as examples of what's going on in the markets rather than a discussion of the merits of these stocks on an individual basis. So again here, Melanie, what are some of the themes you've been seeing unfold around sectors and market capitalization?
Coffin: Sure. There are certainly still areas of the economy that are doing well, but at the same time, there are also areas of the market that are facing pressure, that are starting to show signs of weakness and invulnerability. And so before we dive into some of those themes, I think it makes sense if we take a step back and talk about what we saw over the June quarter from a high level where results really came in stronger than initially expected.
Overall earnings growth was up over 7% on a year-over-year basis. And if we take a look underneath the hood, what was really driving that strength can largely be attributed to the energy sector, which saw earnings rise over 300% year over year. And then at the same time saw top-line growth-- around 80% year over year.
But again, obviously, there are some areas of weakness, really broad-based weakness across the board. But where we felt that pain most acutely was really in the consumer discretionary and the communication services sectors.
Now just switching gears and getting a little bit more micro here, in terms of the themes, I think there's really two things that I would call attention to. The mega caps and then also the consumer. Now starting with the mega caps, over the last 12 to 18 months or so, these have been a really good place to hide out.
Mega caps have provided more ballast for portfolios as we've worked through these periods of volatility over 2021 and 2022. Now, over this quarter, what we did end up seeing was more of a mixed bag with results. And I think we can lay this out in a division between companies that were more centered around software, cloud technology, data centers.
Those companies exhibited a lot of resilience, and then companies that were more tethered to ad spend. And those companies faced a more challenging backdrop. Now when we think about ad spend, from a corporate perspective, it tends to be one of the first things to go in a challenging environment.
And so if we think about the backdrop today, just kind of the confluence of factors that companies are dealing with, from pricing pressure to rising rates and concerns around a recession, we are seeing a weaker advertising demand environment.
And so companies, and specifically mega caps with outsized exposure to ad spend, you can think of names like Meta, Snap, Twitter, those names generally disappointed. And then also in some instances guided down. And then at the same time, we're seeing this shift in both the regulatory landscape and the competitive landscape.
And on the competitive side, you have companies like Tik Tok [a unit of ByteDance], for example, coming in and starting to take market share from Instagram, from Facebook [both subsidiaries of Meta]. So that was certainly an area that-- that faced a bit of pressure as we worked through the second quarter earnings.
But, on the other hand, we started to see and continue to see that resiliency with companies that are more involved with-- software and cloud technology. So you can think of your Googles and your Microsofts of the world. Then I mentioned, the other theme that I think is worth highlighting is really centered around the consumer.
This has been something that a lot of folks are really hyper-focused on. Just thinking about the consumer in general, how is the consumer managing through this environment? And one of the overarching themes that we saw with the June quarter is that ultimately-- pretty limited credit concerns surfaced, with the exception of areas where you'd expect like subprime, low-end consumer.
And so the takeaway in our view is that the U.S. consumer really does continue to show signs of strength. And so if we think about the U.S. consumer really in two segments, you have the high-end consumer and then the lower to middle-end consumer.
Starting with that lower to middle-end consumer, they're seeing good income growth, low unemployment, elevated fiscal assistance. And then at the same time, there's this tailwind with the wealth effect. because of the appreciation of the housing market, the wealth effect is largely quite positive.
So that's a pretty strong backdrop for the low to middle-end consumer. And then for the high-end consumer, not seeing as strong income growth. Wealth effect, not necessarily as positive, a bit of a drag because of the stock market.
But ultimately, we feel like there's a pretty minimal impact, given just the massive cash positions we're seeing in this cohort. So when we think about that dynamic with the consumer, one of the big trends that we're seeing is a shift in spending from goods to services.
Now if you pair that behavior with consumers feeling pinched from inflation starting to cut overall discretionary spending, especially on the low end of things, you have a situation where retailers are dealing with diminished demands for goods.
And so, as a result, a lot of these retailers are finding themselves in this over-inventoried state. And I think what we also saw, an interesting dynamic is that corporations and companies and management were ordering in excess to try and get ahead of these supply chain backlogs that backlogs that really plagued 2021 and 2022.
So that just exacerbated this problem where a lot of these retailers just have too many things. So it's not to say that we have a broadly negative view on retailers. I would say there are certainly still bright spots across the board. And, what we're looking for are retailers that we feel are exhibiting competency from a management perspective.
So, for example, retailers like Target have introduced some pretty dramatic promotions to clear through this excess product. And so while that might cause, some short-term challenges for the company, we think ultimately that's going to pay off over the medium to long term.
So there's still opportunity, but you need to be cognizant of the operating environment. And it certainly is a little bit more difficult for a lot of these retailers. Now in terms of who's winning in that space, I think there are two things at play here.
The first is this idea of “revenge travel,” where folks were cooped up for six, 12, 18 months. And everyone wants to get out, go on a vacation. This also plays into that narrative I mentioned earlier where consumers are prioritizing services over goods.
And so that desire to travel is holding up well. So we're seeing strength in areas like hotels. And then, another area where we're seeing some strength or potential strength is this idea of the trade-down phenomenon where you're going to see this more acutely in the middle to low-end consumer where they're going to begin to make choices about where that next dollar goes.
And so we're going to see those trade-down mechanisms really start to-- kind of accelerate as we work into the third quarter. And so we do think that there're certainly select retailers that are better positioned to-- to take advantage of this behavior.
So just as a recap, mixed bag with the mega caps not necessarily providing as much defensive positioning as we've seen over the last 12 or so months. And then continuing to see strength from the U.S. consumer, but of course, there are hiccups, there are areas of vulnerability that you need to be cognizant of.
Foerster: Just thinking about the idea of revenge travel-- and I did participate in that as well -- but the idea that that was such a big phenomenon and there were such beneficiaries of that. But now that summer's over, you kind of wonder if that continues or if, consumers start to say, "Wow, I spent a lot on that revenge."
And starting to think ahead, which kind of gets to the next question is about guidance. A lot of what we've talked about so far is what happened in Q2 and, which is, of course, a report card on the past. How has guidance started to evolve? Or has it changed in the past few months kind of looking ahead?
Coffin: So for the third quarter, what we've seen so far, I'm going to throw a few numbers at you guys, is that over 60 companies in the S&P 500 have reported negative earnings guidance for Q3. Forty companies have issued positive earnings guidance.
And there's this interesting phenomenon that we tend to see where over the first two months following quarter end, we see earnings revisions typically come down for the following quarter. So over the past ten years, the average decline in the first two months of the quarter has been around 2.7%.
Now what we saw over July and August is that the third quarter bottom-up earnings estimates decreased by 5.4%. So obviously, this is a much larger margin than what we have seen on average. And I think this again speaks to a lot of pessimism out there.
But maybe some of that sent-- that negative sentiment and concerns aren't necessarily reflected in the numbers that we're looking at today, in the estimates that we're seeing from the street. And so if we take a look underneath the hood just one level deeper, at the sector level, nine of the 11 sectors saw a decrease in that bottom-up earnings estimate for the third quarter, looking at June 30th to August 31st.
And the real stand-out in terms of what was moving the opposite direction, what was doing well was energy with an increase of nearly 10%. And then real estate was modestly positive. And in terms of the most negative sectors, that was communication services and information technology.
And then just more broadly speaking, on a calendar-year basis, 2022 estimates came down over that two-month period from 229 to around 226, and then for calendar year 2023, estimates came down from around 250 to 243. So, if we're looking back in the rear-view mirror, there certainly have been some companies that have been able to navigate, this more difficult operating environment.
And, thinking about Q2 earnings in aggregate, companies did better than the street expected. But at the same time, and especially in light of what we saw at Jackson Hole, there's a lot of uncertainty out there. And when we think about how companies are going to do in 2023, that really remains an open question.
00:17:36;14
Foerster: And I would say it's probably safe to say that-- that some of these numbers are going to come down, certainly on the sell side, you're now starting to see some significant ratcheting down of-- of expectations for 2023 earnings.
And I don't know that we would totally disagree with that. Maybe the magnitude is, it's certainly starting to widen in terms of the probability or the range of where earnings might land next year. But you can't, but it's hard to imagine an environment where you're going to have aggressive increase in rates. Where they're clearly almost stating that they want to have demand destruction and not see an impact to the bottom line of many industries. Doesn't mean that you just exit equities. But it probably is a good reason to maybe not have a passive approach to the equity market.
We've been talking for years now about a different framework getting kind of away from just growth and value and thinking about innovation. And then sort of the consequences of innovation are vulnerability. companies that are now maybe not as competitive as they used to be because they are falling behind in terms of technology-- and adaptability to the displacement risk of innovation.
And then sort of a third category of durability. Companies that have-- a lot of resiliency and are able to avoid that displacement risk. And those three categories we think is a good way for investors to think about the markets, equities, and really just the whole competitive dynamics of the economy.
And if you think about this, the new vulnerability is not just displacement risk, but it's also inflation itself. can companies that have done well in a super low rate, super low inflation environment continue to do well? Or are there easy substitutes? You talked about consumers-- kind of battening down the hatches, and-- and maybe starting to make choices about where they're going to cut. Some companies right now have new vulnerability because of that.
And so on the flip side of that, within innovation, there are actually probably many companies that will be problem-solvers for inflation. In fact, we talked about this in the prior podcast with Jeff Herzog, and then also with Ben Ebel, as we talked about the problem-solving nature of many areas of innovation.
So you think about automation, artificial intelligence are likely going to be employed more to combat rising input costs. On the flip side, you think about companies that would fall in the bucket of durability. Companies that have great pricing power.
They may not be innovators, but they have products or services that-- that people are willing to-- to pay more for as prices go up. Those are some concepts that we're really starting to look at from an investment perspective. So it's not all doom and gloom.
There certainly is continued pressure from a macro standpoint. But, we do think there are areas that are pretty resilient even in the face of higher inflation economy and a higher interest rate economy.
Coffin: So Brian, flipping it back to you, talking about innovation, durability and vulnerability, if we want to go I guess beyond that framework, are there any specific pockets or areas that we're seeing as potential opportunity as we go through the back half of 2022 and into 2023?
Foerster: I'd just highlight two concepts. One-- you think about a slowing economy, like, GDP growth is clearly slowing down. We may be in a technical recession already. And we may face more recessionary pressures or at least more pressure on demand.
And what has interestingly been pretty common in the past is when you have a slowing GDP growth economy, that the style of growth versus value tends to outperform. In fact, it tends to outperform more significantly as GDP growth goes down and more frequently.
So that's just one concept to keep in mind. And remember, over the past 18 months, growth as a style has been trounced by value, in part in the beginning because we had the reopening of the economy. And as you have economic growth accelerating, so the flip side, and more participation-- value tends to do very well.
Because it's cyclical. There-- the valuations tend to be lower, so if the growth rates are comparable, you're going to want to own the lower valuation stocks. And then more recently, you've had, sort of stability, more defensive names outperforming, which tend to be more on the value side.
But as growth starts to slow, the scarcity value of earnings growth and earnings stability starts to go up. And where you see that resiliency tends to be in those higher innovation names. some of those mega caps we talked about certainly have that characteristic.
But also areas that are growing regardless of what the economy is doing, so cloud computing-- genomics, medical devices, e-commerce. These tend to be areas that are very resilient in terms of their earning stability. And that tends to be prized as the rest of the economy is slowing down.
So that's kind of number one is growth over value has historically at least worked, as you see GDP growth starting to decelerate. Secondly, and we haven't really touched on this, is the strong dollar. And in environments where you have a strengthening dollar, small caps tend to be preferred.
Because you tend to be focusing on domestic-only companies, or these companies that have most of their revenues if not all of them derived domestically, simply because these companies have not growth yet to become-- global or multinational yet.
So small caps could be an area as well. And if you look at the valuations, and this is something we've highlighted in-- in many papers-- that right now we are kind of in an historical anomaly with small caps trading at such a big discount to large cap names, even though the earnings outlook tends to look a lot better than for large caps.
So you're kind of in this period now where you have a valuation argument, you have a growth argument, and now you have a strong dollar argument. It could be setting up pretty well for-- a period of outperformance from small caps. I think, so with that, I think we're at the end of this episode.
Coffin: I think that all makes sense, Brian. And so, I guess just recapping what you just highlighted, we have this framework of innovation, vulnerability, and durability. And so, as an investor, you really want to avoid those areas of vulnerability and then seek out those areas of innovation and durability.
And then, going beyond that framework, it seems like as we move forward, there might be a preference for growth, just because we are entering potentially this low [economic] growth environment. And that does tend to be a tailwind for companies that exhibit that ability to grow.
And then at the same time, potentially a good backdrop for small caps as we continue to see a strengthening dollar and those businesses are a little bit more domestically oriented companies relative to those larger multinational businesses. So thank you again for having me. I appreciate it. I think this was a great discussion, and hopefully we can talk again following Q3.
Foerster: And I'll just say thanks to Melanie. I think this was great stuff. I think we covered a lot of the key points around corporate earnings and what may be ahead for the markets in, say, the next 18 months. Again, for listeners wanting to learn more about Lord Abbett's view on innovation, on the equity markets and certainly on Q2 earnings, we'd encourage you to read the Market View piece that I referenced a few times in this podcast.
You can find that paper on the Insight section of LordAbbett.com, with the title Second Quarter Earnings Offer Some Early Signs of an Equity Market Bottom. And you can also contact a Lord Abbett representative to get a copy of that paper. And so we'll leave it there. This has been the Active Investor Podcast.
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