Mixed signals are making it difficult to get a read on the economy and the market.
- Consumer spending and liquidity are high, yet consumer sentiment is at the lowest level in decades.
- GDP is anticipated to come in either weak or at recession levels yet S&P earnings estimates show strong growth.
This article will dive deep specifically on the GDP vs earnings issue in an attempt to get an honest read on the fundamental outlook.
The market’s take
With these seemingly contradictory indicators it would seem one must be right and the other wrong. The market has quite decisively declared that weak GDP and poor consumer sentiment are the correct indicators. Market pricing suggests consumer spending will drop precipitously and earnings will come in significantly south of estimates.
I don’t see it as an either/or. While these indicators have historically been more consistent with one another it is entirely possible that BOTH the bullish and bearish data points are correct.
- consumer spending can remain high despite low sentiment
- Earnings can continue growing even with weak GDP
Allow me to dig into the mechanisms of these data points to show why the data is reading such seemingly contradictory numbers.
Factors that are throwing the data off
There are two major factors that are throwing off the data:
Let’s start with trade. The U.S. trading deficit is at an all-time high approaching $1.2 Trillion.
The graph above goes all the way back to the mid-1900s where there were trade deficits, but the deficits were orders of magnitude smaller such that they almost appear as a flat line on the graph.
This is the first time we have ever had to measure trade deficit in the trillions. It is a big number and as such has a big impact on other aspects of the economy.
With respect to the topic of this article, trade directly impacts GDP and earnings.
Those familiar with the CIGX acronym for the components of GDP know that net exports being negative directly subtracts from GDP.
Without the impact of trade, GDP would be $25.5 trillion.
The massive amount of imports, however, brings it all the way down to $24.4 trillion.
That is a reduction of GDP by roughly 4.3%. Note that 1% GDP growth is considered weak and 5.3% GDP growth would be considered very strong.
Thus, this factor is potentially single handedly pulling GDP from a strong level to a weak level.
GDP accounting – Do imports actually hurt GDP?
The above calculation on the impact of imports on GDP are assuming the purchases otherwise would have happened domestically.
An import that would have otherwise not been produced domestically has no impact on GDP.
If a person living in the U.S. buys a pair of shoes directly from China for $50, it will increase consumer spending (the C in CIGX) by $50, but it will also decrease net exports (the X in CIGX) by $50. Thus, the overall impact of such a purchase on GDP is $0.
However, if instead of importing, that person buys a domestically manufactured pair of shoes for $50, it will be a net +$50 to GDP.
Thus, the negative impact of imports on GDP is via replacement of economic activity that would have otherwise contributed to GDP.
It is unknown how much of the over a trillion dollars of imports is replacing domestic activity. It is not 100% but it is significant. If someone needs a pair of shoes, they need a pair of shoes and will buy it from the U.S. if they can’t import it cheaply.
Trade has a very different impact on earnings
Imports at a company level are usually for the purpose of increasing margins. A company could produce auto parts here in the U.S. or they could import them for cheaper.
The delta between the price of domestic production and the price of the import is an increase to margins.
So as imports have displaced such a substantial portion of domestic activity it simultaneously increases company earnings and hurts GDP.
Why both weak GDP and strong earnings are true
At the outset of this article, we talked about how estimates simultaneously call for weak GDP and strong earnings of S&P companies. The market believes only the weak GDP will come true, but analysts are sticking to their high earnings estimates.
A FactSet report out on June 24 shows that earnings estimates have continued to rise even as the market price has gotten clobbered.
I firmly believe that the analysts are correct, even as GDP is predicted to come in weak.
In normal times, when GDP is weak, company earnings tend to also come in weak.
These are not normal times.
The nearly $1.2 trillion trade deficit is net of exports. If we look at imports alone, it hit an annual rate of $3.9 trillion in 1Q22.
The unprecedented rise in imports is simultaneously displacing a substantial portion of domestic production, thereby reducing GDP and contributing positively to company margins.
Another major contributor to the dissonance between the bullish and bearish indicators is inflation.
Inflation increases earnings while hurting GDP and consumer sentiment
This is the big whammy as it simultaneously contributes to three indicators.
The impact on sentiment is quite straight forward. Just about everyone buys gas and food. It makes me rather grumpy paying $5 for a box of cereal that used to cost $3 or paying $70 to fill up my tank. I suspect just about everyone feels the same way so is it really a shock that consumer sentiment has declined?
The impact on earnings and GDP is also straight forward.
- Earnings are measured in nominal dollars
- GDP is measured in real dollars
Ceteris paribus, with 8% inflation, earnings will come out 8% ahead of GDP.
I don’t find it all that shocking that analyst estimates for earnings have remained high. Companies have largely passed on cost increases to their customers, keeping margins about the same. Higher revenues at the same margin naturally means higher earnings.
GDP is slightly negatively impacted because inflation can in some instances reduce quantity of units sold. Elasticity of products usually functions with respect to nominal price rather than real price. Consumers see things costing more so they try to conserve and buy less.
Outlook on economy and earnings
Given the size of impact from trade and inflation I think it is likely that BOTH:
- GDP will come in weak
- Earnings will come in strong
I see this as bullish because the market has already priced in company earnings substantially missing analyst estimates.
If earnings come in at the strong growth rate that the estimates suggest, I anticipate a nice rebound throughout the market.