Hope From the Fed; Earnings On Tap

Stocks opened lower this morning, but quickly turned around. Currently, the Dow is up 22 points and the S&P 500 is down .3%. Most commodities are trading lower. WTI crude edged back below $91/barrel. Bonds continue to sell off, sending yields higher. The 2-year Treasury Note yield ticked up to 4.31%.

Out of nowhere, two Fed officials just mentioned the possibility of pausing interest rate hikes some time in the near future. Chicago Fed President Evans said the Fed needs to quickly raise rates to a level at which they feel comfortable stopping to monitor and assess the impact of previous monetary tightening. This will lower the risk of “overshooting” and driving the economy into recession. Fed Vice Chair Brainard also acknowledged a policy lag, saying it will “take some time for the cumulative tightening to transmit throughout the economy and to bring inflation down.” At this point, she seems to favor a “data-dependent” approach. These comments are shocking as they represent a clear departure from the Fed’s recent tone. During Chair Powell’s last press conference he wouldn’t even discuss a scenario in which the Fed would pause rate hikes. Clearly, traders sat up and took notice; the Dow went from down 290 points, to flat over the last hour-and-a-half.

Nonetheless, it’s now fairly clear that capital markets are pricing-in a mild recession. Stocks are down 20-30%, bonds are down 10-30% The investment community is just beginning to worry more about that than about the Fed. Therefore, most investors believe corporate earnings will end up taking a big hit next year. Certainly, the removal of fiscal & monetary stimulus, higher interest rates and a strong dollar will should reduce sales and profit margins for most US companies. So why are Wall Street consensus earnings expectations implying such healthy growth? Even today, ten months into a bear market, analysts’ official projections call for 7-8% earnings growth this year and next.

Leuthold Group’s Jim Paulsen has a theory. He points out that since March 2021 inflation has surged to the highest level in decades, but corporate profit margins are holding up relatively well. And while many CEOs “have expressed grave concerns about the possibility of an imminent recession…their actions don’t seem to jive with such worries.” Employment activity is still positive, and companies continue to “spend robustly” on capital goods. Perhaps that’s because business activity is still positive and growth hasn’t fallen off the table. The Federal Reserve predicts economic growth will be flat this year and modestly positive next year. But that prediction refers to “real” or inflation-adjusted growth, whereas nominal growth is expected to remain above 5%. And remember, corporate earnings is reported on a nominal basis. Paulsen argues that as long as we don’t experience a “deep” recession—that is, economic growth doesn’t contract—corporate profits will likely continue rising. He conclusion: The death profits is greatly exaggerated.

Third quarter earnings season kicks off this week. Beginning Wednesday publicly-traded companies will report key metrics like sales and profits, as well as discuss business trends and forward guidance. Pepsico (PEP), Dominoes Pizza (DPZ), Blackrock (BLK) and Delta Airlines (DAL) are first up.