Good morning! Yesterday was quite a challenging day for the US. Our former president was indicted, and Fitch downgraded our debt, mainly due to a decline in governance standards over the past 20 years. We are still uncertain about the magnitude and significance of these events, and we value your thoughts on the matter. Feel free to reach out to us at [email protected] and [email protected].
Let’s talk about the current earnings season and the so-called “soft landing.” While the headline numbers may appear a bit weak, a closer look reveals a resilient economy that continues to support strong corporate performance. Most companies are not performing as well as they did a year ago, but they are still in a relatively good position.
According to FactSet, S&P 500 earnings for the second quarter are expected to decline by 7.3% compared to the previous year. This is the largest drop since the onset of the pandemic. However, it’s important to note that these declines are concentrated in specific sectors such as energy, materials, utilities, and healthcare. The first three sectors are experiencing the impact of the commodities cycle, while the healthcare sector is facing high costs and some unique challenges at the company level.
Despite the decline in headline earnings growth and flat sales, it’s difficult to see a widespread cyclical slowdown when sectors like industrials and financials are still showing solid growth. For example, Caterpillar, a key cyclical bellwether, reported 22% revenue growth and 32% growth in North America. These corporate results align more with a return to normalcy after the exceptional period of the pandemic.
Although margins are continuing to compress, this is expected as inflation cools down and demand reaches a balance. According to FactSet, net profit margin is projected to be 11.3% for the quarter, a full percentage point lower than last year. However, what is concerning is the expectation from investors that this quarter represents the low point, with a sharp rebound anticipated. It’s worth noting that the pace of margin decline has slowed, but it’s unlikely that margins will return to the exceptionally high levels seen during the pandemic.
A positive sign for long-term optimism in margins is the increase in company investments. Companies that have reported so far have seen a 15% growth rate in capital expenditures. This is a welcome change after years of under-investment. However, it’s important to keep in mind that the benefits of fixed investment take longer than a year or two to materialize, and in the short term, they can impact margins by raising depreciation expenses.
In summary, the second-quarter earnings news aligns with the growing popularity of the “soft landing” forecast on Wall Street. However, while we have reduced the odds of a recession in the near term, we still believe that the chances remain significant (more than one in three). There are two key reasons for our cautious stance: the tight labor market and the time lag associated with monetary policy.
Concerning the labor market, Strategas’ Don Rissmiller highlights that the US economy is operating at a pace that requires 171 million workers, but we only have 167 million available in the labor force. If labor supply remains constrained due to aging demographics, it implies that labor demand should decrease. The softest way for this adjustment to occur would be a decline in job openings rather than job losses. However, there is still a risk of both occurring. As long as there is an imbalance between labor demand and supply, the central bank is likely to continue its restrictive policy.
On the second point, David Rosenberg points out that talk of a soft landing is often popular late in an economic cycle before a recession occurs. Similar discussions have happened in the past, preceding the 2001 and 2007-2009 recessions. It’s important not to get carried away with optimism despite strong economic data and corporate earnings reports. The labor market and the lags associated with monetary policy should temper any excessive exuberance.
Moving on to another topic, let’s discuss the recent Kirschner vs JPMorgan court case, where the classification of syndicated bank loans as securities is being debated. This case has significant implications as it may disrupt the $1.4 trillion leveraged loan market, which consists of sophisticated players who are not necessarily in need of additional regulatory protections. The Securities and Exchange Commission (SEC) was asked to provide an opinion on the matter, but strangely, the agency declined to do so after seeking multiple extensions.
Behind the scenes, officials from the Federal Reserve and the Treasury urged SEC Chair Gary Gensler to reconsider his position, arguing that categorizing bank loans as securities would negatively impact the already fragile debt markets. As a result, the SEC decided to shelve a legal brief that would have required bank loans to have the same disclosure requirements as stocks and bonds.
The situation is complex. The legal argument against classifying loans as securities is based on a 1992 precedent called Banco Espanol. In that case, an appeals court determined that syndicated bank loans resembled traditional loan participation agreements between commercial banks and were not securities. However, the decision was based on a narrow interpretation, ignoring the SEC’s view that the loans should be considered securities. The chief judge in the case dissented, stating that the decision was flawed as it overlooked information discrepancies between commercial banks and non-bank investors in syndicated loans.
Ann Lipton, a professor at Tulane Law School, shares the belief that the case was wrongly decided, considering the current landscape and growth of the industry. However, changing the legal status of an asset class, even if justified, becomes challenging once it has grown significantly. In this case, blowing up the industry is not the court’s intention. However, the issue highlights the need to evaluate the regulatory framework for leveraged lending.
Before we conclude, it’s worth mentioning that industrial policy is gaining traction within the economics discipline. This represents a shift in thinking and could have significant implications for economic strategies and policies.
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