2023 – A year of infinite possibilities: Part 2 – Late cycles and recessions
As we knock on the door of 2023, infinite possibilities await the global economy and financial markets. Until recently, the bearish consensus was dominating the narrative: war, imminent recession, profits will fall, the stock market will plummet.
Then US inflation slowed by 1.1% in just two months. The imminent recession chatter is being challenged by persistently resilient economic data and a few contrarians who still think a soft landing is possible. The only certainty is uncertainty.
As the story unfolds, perhaps the path will become clearer. This three-part series is an attempt at mapping that path, or better said, possible paths. The optimal route is unlikely to be known until the ever-reliable 20/20 hindsight kicks in (around this time next year).
In part one we covered, forecasts, wages and the world's biggest consumer. In part two below we examine the impact of the rising rates environment and the effect on the economic cycle and potential for a company earnings recession to drag stock valuations lower. In the final part we'll move on to central banks, China and commodities markets.
Part two: Late cycles and recessions
To navigate a challenging period, it’s useful to have a framework. Something to follow to ensure that the signal isn’t lost among the noise.
Michael Kantrowitz (Piper Sandler Chief Investment Strategist) has a HOPE model that offers an excellent base to work from.
As the most rate-sensitive sector, Housing tends to fall first. Followed by (new) Orders, then Profits, and finally, Employment. H.O.P.E.
Indeed, US existing home sales just posted their worst annualised drop EVER. Piper Sandler’s Demetri Delis commented:
“Home resales fell in November for the tenth consecutive month and are now near their lowest levels since 2010, when one excludes the COVID related low prints. On an annual basis, the pace of sales was down by a new record low of 35.4%.”
The National Association of Realtors added "In essence, the residential real estate market was frozen in November, resembling the sales activity seen during the Covid-19 economic lockdowns in 2020."
US home prices are expected to decline by 12% from peak to trough, according to a Reuters poll of analysts.
Onto the orders. It’s clear that demand is beginning to normalise. Focusing on the ISM surveys, the November new orders reading for the manufacturing sector is already in contractionary territory at 47.2.
For the non-manufacturing sectors however, November orders were still relatively strong at 56. Admittedly, that’s down from the 60+ readings seen in August & September, but still well above the 50 level that separates growth and contraction.
Taken as a whole, demand, as represented by ISM Orders, is slowing. Following the Kantrowitz framework then, next year is likely to see a focus on (falling?) profits in the first half of the year and employment concerns following on from that.
What is your sentiment on MU?
What could negatively impact company profitability?
The obvious answer is falling consumer demand. If consumers are demanding fewer goods and services, it’s harder to keep pushing prices even as costs stay constant or continue rising. Companies may find themselves overstaffed, or holding too much inventory that will need to be discounted to clear.
It’s important to note that the HOPE framework is referring to a ‘critical mass’ effect on the overall economy. Tempting as it is to highlight companies such as Amazon (AMZN) or Facebook/Meta (META) (which have already reduced headcounts in response to falling profits), this is more of a localised story.
Focusing purely on the tech industry can be misleading. There was already a case that fast-growing companies might be carrying too many staff and excessive overheads before the pandemic. Then, a wave of optimism and a belief that the world had entered a new paradigm of online commerce led to more overheads being added.
As the economy normalised, it became evident that this was more of a step forward rather than a leap. Tech companies have been downsizing staff numbers for a while now, with over 240,000 global tech jobs cut so far in 2022, per LayoffsTracker:
Tech companies are normalising those new paradigm additions more than reducing the size of the overall business.
Pandemic demand ends for Micron
Back to those profits. We’ll get a first look when earnings season ramps up again from mid-January, and we’re already seeing hints of what’s to come. Micron’s (MU) 2022 journey has been a microcosm of pandemic demand not lasting. The company’s optimism has faltered further with each passing quarter, culminating in falling revenues and a gross margin collapse in the latest report.
- Micron last quarter: Revenues $6.4 billion. Gross Margin 39.5%
- Micron this quarter: Revenues $4.09 billion. Gross margin 21.9%
In more concerning news for Micron, its inventories are increasing. The inevitable bullwhip effect is still playing out, meaning Micron needs to further cut production (meaning job losses for 10% of its employees) until supply and demand find a better balance.
CEO Sanjay Mehrotra told analysts on the conference call: "Due to the significant supply/demand mismatch entering calendar 2023, we expect that profitability will remain challenged throughout 2023."
Micron (MU) share price chart
A perfect example of the Profits under pressure dynamic mentioned back in October.
Nike in a better position
Not all companies are equal though. Nike (NKE) is churning through its excess inventory without excessive discounting. Those billions spent on brand advertising really do work.
Goldman’s summary highlighted the positive progress in reducing inventory levels without sacrificing too much in the way of profits:
“While management has taken actions to liquidate excess inventory, Nike highlighted that Nike brand ASP (Average Selling Price) was up Y/Y in the quarter across all geographies (with strong performance in footwear a key driver).”
Nike (NKE) share price chart
So, will 2023 be more Nike, or more Micron?
Morgan Stanley’s Mike Wilson thinks we’re in for a proper earnings recession. Even though everyone understands that profits will fall, he says we’re just not prepared for the magnitude of that drop.
Even worse, the complacency is dragging up worrying memories and echoes of 2008…
Wilson says: “We often hear from clients that everyone knows earnings are too high next year and, therefore, the market has priced it. However, we recall hearing similar things in August 2008 when the spread between our earnings model and the street consensus was just as wide.
“We don't expect a balance sheet recession next year or systemic financial risk. However, the earnings recession by itself could be similar to what transpired in 2008/2009. Our advice — don't assume the market is pricing this kind of outcome until it actually happens.
“In short, if our EPS forecasts prove to be correct, the price declines for equities will be much worse than what most investors are expecting. Based on our conversations, the consensus view on the buy side is now that we won't make new lows on the S&P 500 next year but will instead defend the October levels/200-week moving average, or approximately 3500-3600 on the S&P 500. We remain decidedly in the 3000-3300 camp with a bias toward the low end given our view on earnings.
“As a final comparison to August 2008, we have put together a table comparing key statistics from then and now:”
The past is never a perfect prologue, but the points around complacency are worth bearing in mind. Profits in peril is one of the big risks for the stock market valuations in 2023.
If central banks stick with their higher for longer interest rates, disappointing rates markets that are already pricing cuts for the second half of 2023, that risk is likely to be amplified.
Which we’ll dig into further in part three.
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