Strong GDP, Narrowness, and Earnings Warnings

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Welcome, market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

Stocks flying, spreads tightening, GDP rebounding—it’s all good right? Remember that seemingly fringe book of yesteryear, 1999 to be exact, Dow 36,000? That’s when the Dow was at 10,000, and their forecast was for three to five years out. Sure, they were early, like 20 years early, but all of the sudden we’re there, and then some. Here’s to Dow 100,000.

This week, our 3 Things are:

1. That GDP report. Everyone—literally everyone—missed this. Here are our takeaways.
2. Narrowness. Beware of the aggregate statistic.
3. Earnings warnings. Underneath market euphoria is some sobering guidance.

Alright, let’s dig a bit deeper.

A whopper of a GDP report.

3.3%. That’s just about double what the Fed’s longer-term growth estimate is for the U.S. And at a time of significant monetary tightening and acute awareness, at least among businesses, that a recession remains a distinct possibility in 2024.

3.3%. Wow. By now you’ve read that of the 68 economists surveyed by Bloomberg, 3.3% was higher than every single estimate—by a ton. 2.5% was the highest in the group. Sure, the so-called volatile categories (inventories, net trade) accounted for much of the upside surprise, but it is what it is, a surprisingly strong outcome in the wake of the strongest monetary hiking cycle in 40 years.

Here’s our takeaways:

1. Consumer spending (+2.8%) just won’t quit … yet.

• Excess savings remain larger than most expected (BofA says deposits across consumer income groups are 135% of pre-pandemic levels).
• Wage growth has beaten inflation growth in six of the past seven months.
• Jobs remain plentiful, as 96.3% of the labor pool has a job, and the security of knowing that if they were to lose one, they should be able to find one quickly.
• Household net worth is just off of record highs.
• Some of those saving for a home have given up and are deploying retail therapy in its place.
• Some consumers are delusional about maintaining a lifestyle that elevated during the pandemic courtesy of stimulus; as savings deplete, they are borrowing via buy now, pay later and credit card availability to keep it all going.

2. Government spending (0.56%) chips in—state and local government hiring drove an increase.

3. Capex (1.9%) is hanging in there—businesses are much more pragmatic than consumers, but confidence in an earnings rebound has brought back a willingness to invest.

Is this the last hurrah? In our opinion, yes, in terms of this sort of outsized strength. We expect consumer spend to moderate over the course of 2024, as many of those factors we mention rationalize, especially excess savings and growth in real wages. But it does strengthen our call for a soft landing. And is likely to push out rate cuts.

Alright, on to our second Thing—Narrowness.

Don’t fight the tape. Words of wisdom, for sure, and we seem to be caught up in one of those moments where that advice is well taken. Don’t fight the tape. Stocks at record highs, spreads well through long-time averages. A quick survey across the media (and BofA’s Global Fund Manager Survey) says the likelihood of a hard landing has gone to a tail event. Have I missed something?

The answer, humbly, is no. Remember back in mid-December—that’s a little over a month ago—we saw a survey of 18 Street strategists that was evenly split on recession/no recession in 2024. Of course, that was before hot retail sales and GDP reports.

Well maybe it’s the same old story, the Magnificent Seven have once again ripped higher, and taken sentiment with them. In fact, technology is the only S&P sector that hit a record high. For what it’s worth, the equal weighted S&P 500 is not at its all-time high, it’s actually 5% below its high set two years ago. The Russell 2000 is 19% lower than its high. Peel back that onion a bit, and a different story emerges. Parts of the economy are doing well, and other parts less so. There is a narrowness to the strength.

We see it in the labor market. Yes, the unemployment rate has been sub 4% for two years now, but private sector job growth over the past six months has come almost entirely from leisure and hospitality, health care, and education. Together, those sectors represent just over a quarter of economic output. The latest manufacturing surveys out this past week from New York, Philadelphia, and Richmond—all decidedly negative, and all missed the estimates by a bunch. Again, a narrowness to economic growth.

Last week, Wells Fargo on its earnings call commented that, in the aggregate, its measures of consumer financial wherewithal “paint a pretty good picture.” But it continues to point out that there are cohorts of people that are more stressed than what the aggregate numbers imply. Management seems to be signaling what our own data is showing in non-prime securitizations, that delinquencies are rising at a rate that warrants close attention. Again, a narrowness to economic prosperity.

How about earnings? Of those same 18 strategists that were split on whether or not we end up in recession, all 18 forecast earnings growth for the S&P 500. Small caps? Not so much. Some 40% of the Russell 2000 is unprofitable according to J.P. Morgan Asset Management.

Yes, leftover effects of the pandemic are clearly carrying the economy, but if you’re trying to see around the corner, keep an eye on small business where half of Americans are employed amidst by what the Russell data suggests is a large quantum of unprofitable companies. And keep an eye on the behavior of the half of American households that live paycheck-to-paycheck. I’m guessing it’s easy for most listeners to lose sight of those.

Alright, on to our third Thing—Earnings disappointments.

So, against the euphoria of that record-setting stock market, that which underpins that market—earnings—has had a growing list of disappointments from a range of bellwethers. Apart from decidedly idiosyncratic stories such as Boeing, and its latest transgressions, the disappointments are less in the form of material earnings misses and more in a softening of 2024 guidance.

3M, whose stock is down 55% since mid-2021, provided more evidence that span of control is challenging in a conglomerate and there is a real cost to a business undergoing a major restructuring. Its newly updated guidance reflects a “muted” macro environment, where demand in core industrial markets in the U.S. is mixed, while China and consumer retail end markets continued to be soft. Its new 2024 guidance calls for earnings to be 1% to 5% below the Street’s consensus.

General Electric is approaching the end of its multiyear breakup of its conglomerate. Investors have cheered the execution of its ambitious plan, with its stock up 61% over the past year. Still, management threw a bit of cold water on the story by signaling adjusted earnings in 2024 are likely to be 7% to 14% below consensus.

Texas Instruments guided its first-quarter sales to a level 8% to 16% lower than estimates, resulting in earnings that are expected to miss by 18% to 32%. Increasing weakness across industrial and a sequential decline in automotive demand is driving the expected softness in the company’s results.

DuPont warned that Q1 sales are expected to be 8% below the Street estimate due to inventory destocking among its industrial customers as well as continued weak demand in China.

Discover warned that losses on its consumer loans are likely to be substantially higher in 2024, as turbocharged growth during the pandemic vintages season.

The important message here is to curb your enthusiasm, rather than duck and cover. The economy is set to slow, notwithstanding that GDP report, and we would expect earnings growth to come down over the course of the year from its lofty, double-digit expectations.

So, there you have it, 3 Things in Credit:

1. That GDP report. The case for a soft landing has strengthened.
2. Narrowness. In the aggregate, all is well; peel the onion a bit and you’ll find pockets of weakness.
3. Earnings warnings. Don’t lose sight of these amidst the record-setting S&P 500.

As always, thanks for joining. Don’t forget to check in on KBRA.com for our ratings reports and our latest research. See you next week.