Could the S&P 500 Index Be too Pessimistic?

07.27.2022: As we run headlong into Q2/22 earnings season, corporate America is juggling multiple issues including inflation, higher financing costs and supply-chain shortages. Walmart’s results, announced on Monday, remind us of the fragility of the American consumer. And just as we thought there were more than enough stresses on income statements, one more worry must be added to the list: a strong dollar. After years of relatively tranquil currency markets, foreign exchange volatility has spiked as global central banks look to rein in the hottest inflation readings in over 40 years. Jay Powell’s Fed is leading the fight, and will likely soon raise the overnight interest rate to its highest level in a decade. Comparatively higher US rates have prompted a capital wave to flow into the US dollar. The US dollar index is nearly 11 per cent stronger this year, leaving it at levels not seen since 2002. But a strong dollar is a double-edged sword.

A bountiful greenback gives US consumers and companies more purchasing power, particularly overseas. The Euro is near parity to the dollar, its cheapest level in about a decade. While the continent may be suffering a heat wave, European restaurants, hotels and other US tourist destinations are about 20 per cent cheaper than they were last year. To US companies transacting business in foreign countries, a strong dollar is a double whammy. It makes their dollar-denominated offerings less competitive than those of their foreign competitors. For example, US-based Caterpillar Inc competes globally against Japan’s Kubota tractors. Simply adjusting for the USD/JPY exchange rate, prices of Caterpillar tractors have risen more than 21 per cent vs Kubota tractors over the last 12 months. And a stronger dollar dilutes revenue repatriation, not letting as much of the top line drop through to the bottom line.

Graph 1, Market Update 7.27

Already, dollar strength has wiped out billions in Q2 revenues of US companies, prompting management teams to cut guidance for the remainder of this year. That’s because roughly half of S&P 500 companies’ revenue is derived abroad; for tech companies it’s 60 per cent. So far this quarter, Pepsico, Johnson & Johnson, IBM and Netflix are among the high-profile companies that have blamed dollar strength for revenue misses, lower profits and other miscues. Companies with the highest share of foreign revenue have underperformed the overall market by nearly five percentage points this year.

Graph 2, Market Update 7.27

Though they’re not talking about it, Biden administration officials are embracing the dollar’s strength. That’s because a stronger currency helps keep imported goods, including commodities like energy, incrementally cheaper. The benefit they tout, however, is incremental. In fact, the dollar’s impact on prices will do little to curb the Fed’s inflation fight. Analysts estimate this year’s dollar rally equated to roughly a 15bps hike in overnight interest rates – small potatoes as the Fed tightens in multiple 75bps increments.

Q2 revenues remain strong, although an increasing share of companies are falling short of expectations. Top-line growth is expected to have advanced 10 per cent over last year; save for the impact of the dollar, it would have expanded 12 per cent. With just under one-quarter of market value having reported so far, S&P 500 profits are on track to rise about 5.5 per cent year on year, slightly better than pre-season consensus estimates of 4.1 per cent. At this point 72 per cent of reporting companies have beaten their revenue estimates, although that figure is about six percentage points below the historical median. Same thing for bottom-line beats: just over 55 per cent of companies reporting Q2 results have outpaced their profit expectations. That figure is typically over 60 per cent.

Graph 3, Market Update 7.27

To the extent a stronger dollar and a bevy of other economic uncertainties are weighing on the outlook for future profits, it doesn’t appear to be reflected in analysts’ longer-dated profit projections. Analysts are looking for 10 per cent earnings growth in 2022 and 7.6 per cent growth in 2023. Next year’s forecast has been trimmed from the March consensus forecast of 10 per cent. Nonetheless, this downward tilt in growth expectations appears inconsistent with the stock market’s performance since then. Our weekly gauge of earnings revisions shows downgrades are slightly outpacing upgrades, but are generally well behaved. Perhaps the S&P 500 Index is too pessimistic?  The good news: it seems a fair amount of profit pessimism is already priced into equities.

Graph 4, Market Update 7.27
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