By Ron Saba, Senior Portfolio Manager
By Ron Saba, Senior Portfolio Manager
If 2021 was all about “reopening” the economy and how that would affect corporate earnings (spectacularly, it turns out), 2022 will be all about managing through “uncertainty.”
Next year is shaping up to be an unusual year in that companies are wrestling with a dizzying array of problems – from supply chains to taxes to wages – that are all hitting at once, which we go into in further detail below.
Let’s be clear, uncertainty isn’t necessarily a bad omen. In markets, surprising outcomes can lead to volatility, which opens the door to opportunity. At Horizon, we believe the key to harnessing volatility for investing success is to war game the possible outcomes, examine market positioning against each of those probable outcomes and then adjust our portfolios – if necessary – to try to anticipate how markets may move.
Will the equity market reaction be negative to the earnings issues below? Perhaps not. A dramatic earnings growth slowdown is widely known. S&P 500 earnings are seen rising 8% next year after rising by double-digits in 2021, according to data compiled by Bloomberg. With investors well informed about that, it may not take much of a positive turn to put a smile on their faces. Investor psychology is perhaps the biggest “uncertainty” for 2022.
Below, in no particular order, are the variety of factors we are watching for insight into the path and magnitude of earnings:
Global Supply Chain Distributions
While we believe the supply chain issues that we are all reading about will be resolved sooner rather than later, we anticipate their impact to domino into next year. Recent corporate financial reports highlight the impact it’s having on both costs and sales. Companies are experiencing higher costs due to the extraordinary measures required to procure raw materials and maintain production levels. On the sales side, Bed Bath and Beyond and Sherwin-Williams’ comments about not being able to capture sales because of out-of-stock items highlights the widespread nature of the problem. Still, no company manager wants to let a sale slip away because of a lack of product. Necessity is the mother of invention. And if 2020’s earnings reports showed anything, it’s that corporations large and small are able to adapt and find creative ways of solving problems. There is likely a mountain of changes coming, but we won’t necessarily learn about it until companies report their earnings. Take Tesla as an example. It’s higher than expected deliveries in its most recent quarter shows that not all car manufacturers are being hobbled by the semiconductor shortage.1 The supply chain headaches are currently bad, but we should be prepared for some companies – even perhaps many – to creatively work their way through it.
Wage Inflation & Labor Availability
The current labor shortage is requiring companies to raise wages to attract people – leading to the highest wage inflation in years, especially for low wage workers. According to Goldman Sachs, low-wage wage growth is currently 6%, the highest pace in three decades and a point above the prior peak growth rate of 5% reached during the tech-bubble peak in 2000.
Companies are bracing for the labor shortage to linger into next year. FedEx’s recent quarterly earnings showed a $450 million year-over-year increase in costs due to a “constrained labor market that impacted labor availability, resulting in network inefficiencies, higher wage rates, and increased purchased transportation expenses.” What’s the way out of a worker shortage? In the past, the answer has been technology. There’s no obvious reason why technology won’t be employed again as an answer. Whether that’s internet-connected factory machines, more warehouse robots, more self-ordering kiosks or some “there’s an app for that” invention, companies have always adopted labor-saving machines. The hard-to-answer question is how long it will take a company to buy and install the next breakthrough that helps more money fall to the bottom line.
This is the most insidious issue, as every single company and consumer is affected. Crude oil prices have nearly doubled over the past year. Companies have a choice to make: absorb higher energy costs at the expense of margins or maintain margins by raising prices? If energy prices remain elevated or continue to rise, expect higher energy costs to impact corporate profits for at least the next several quarters as it takes time to raise prices. A decline in energy prices, however, could benefit companies, especially those that have passed through the higher cost.
Consumer Confidence And Covid Cases
We’ve seen a relationship develop this year between the rising and falling of Covid cases and consumer confidence readings from the Conference Board.2 The late summer increase in infections has weighed on Americans’ optimism. However, should Covid become just another seasonal virus – in medical terms it becomes endemic, rather than pandemic – then fewer cases could lead to more consumer spending, driving up U.S. economic growth, which in turn benefits corporate profits. On the other hand, Covid’s twists and turns have often defied prediction, and consumer confidence may yet be held back by new variants.
This issue is in flux as we write. The current consensus view is that the changes Congress is contemplating to corporate taxation will lower S&P 500 earnings by about 3% in 2022. That means instead of roughly 8% earnings growth for the index, it might be more like 5%. The predictions are educated guesses; it’s the details of what’s eventually passed that truly matters for determining the potential impact of higher taxes. Still, when we do have the details in hand, be wary of bold predictions. The Wall Street Journal pointed out in late September that some profitable companies may still pay no taxes under the Democrats’ proposal.3
Federal Reserve Policy
Interest rates matter, but the Federal Reserve’s rationale for raising rates (if they decide to raise rates) matters more. If the central bank is combating inflation even as GDP growth is slowing, the specter of stagflation will appear, which may weigh on the profit outlook. However, if rates are going up because the economy is strong, job gains meet the Fed’s definition of “maximum employment,” and supply bottlenecks are clearing, that might be an upbeat signal for profits. In the past, rising interest rates in a strengthening economy have been positive for banks, which thrive on the spread between the cost of money and the interest rate on the loans they’re making. Should it become clear during 2022 that the Fed will be embarking on a cycle of rate hikes, the stage could be set for financials and other interest-rate sensitive sectors to outperform and for growth and innovation stocks to take a pause.
1 Wall Street Journal, “Tesla Deliveries Surge, Defying Supply-Chain Woes,” Oct. 2, 2021
2 Conference Board, “Consumer Confidence Fell Further in September,” Sept. 28, 2021
3 Wall Street Journal, “Some Profitable Companies Would Still Pay No Taxes Under Democrats’ Plan, Sept. 24, 2021
The commentary in this report is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here are not investment recommendations, but rather opinions that reflect the judgment of Horizon as of the date of the report and are subject to change without notice. Opinions referenced are as of the date of publication and may not necessarily come to pass. Forward looking statements cannot be guaranteed.
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