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Aggressive moves by central banks to tackle inflation have sparked concerns about a potential economic recession. But Damian Fernandes, Portfolio Manager at TD Asset Management, tells Greg Bonnell the focus should be less on recessions and more on what earnings revisions are telling us.
Transcript
– Well, the market headlines are increasingly dominated with questions about a possible recession, but our feature guest today says investors should be focusing more on what’s happening with corporate earnings. Joining us now, Damian Fernandez, portfolio manager with TD Asset Management. Great to have you here. I mean, that does hold true. Every time you take a look on your website, any feed you follow about business investing — recession, recession, recession. You say, that is the wrong place to focus.
– Yeah. Thanks, Greg. I think people, they’re inundated with this new cycle that are we going into recession, are we not going into recession, what’s happening? For all practical purposes, we are in recession. What I mean by that is that in the US, at least, Q1 GDP was negative. When you look at the Federal Reserve’s owned estimates, the Atlanta Fed publishes this GDP now forecast, it’s tracking negative for Q2. But GDP, it’s axiomatic that GDP, employment are lagging indicators.
When you look at leading indicators, consumer sentiment, building permits, purchasing manager indices, they’re all slowing materially. So I think the question is whether– whenever the it’s marked that’s the recession, I think that’s the wrong question. The question really should be what’s happening to earnings. Because ultimately, it’s earnings that drive performance of what we’re talking about today. Cash flows of stocks and whether they — and how volatile they’re going to be.
– So let’s talk about some expectations on that front in this environment, and we have seen the slowdown in the economy. We have soaring inflation. What should we expect out of corporate earnings, and corporate earnings revisions perhaps even more so?
– Yeah, so in — next week, it’s going to be the start of Q2 reporting season in the US. You’ll have a few of the big banks report. I think it’s one of the airlines is reporting next week. So we’ll get a sense of it. My best guess is that, look, we’ve just talked about what’s happening in the economy in real time. We’ve talked about the dollar strengthening and that weighs on earnings that these US companies earn overseas.
We can talk about what’s happening in Europe likely going into recession. China fits and starts and reopening. All of these things doesn’t lend itself to double digit earnings growth, which is still what’s in the cards. Analysts are still expecting something close to 15% earnings growth for this year. So I think Q2 is going to be a breaking point. I don’t know. I’m not sure how markets will react to it, but I think you’ll start seeing companies revise down guidance. And you’ll start — just to try and get a sense, to get ahead of these really lofty expectations, you’ll start seeing companies revise down guidance, and then you’ll see analysts probably take their numbers for 20 — this year, 2022, and likely next year.
– We’ve had discussions on the program in recent days about that very thing. If we start to see corporations take down their earnings forecasts, of course, this changes our notion of what we’re paying up for these names. After this pullback we’ve seen in the markets this year, and you might be under the illusion that stocks are getting cheaper. But if the earnings change, then that part of the equation changes. You’re saying, though, it’s going to be hard to try to figure out how the market’s going to react to that. Do you think there’s enough awareness of that so far?
– Well, I think the market’s been — the market has correctly anticipated this, right. We’ve had one of the most — in the US market, we’ve had, peak to trough, we’ve had more than a 20% drawdown. That’s more than the European debt crisis over a decade ago. So we’ve had a significant repricing of this. So the multiples so far have come down. So what might happen in this scenario is that multiples stay the same and the earnings, the denominator, actually starts getting repriced lower. But look, I think the — I think the negative earnings revisions are ahead of us.
The question is whether they bought them out, or when do we start seeing growth in the economy. Again, I don’t want to sound it’s all doom and gloom because I do think that, particularly, if you’re thinking about stocks specifically, you want to be focused on stocks, which have fared a fair amount of that pain, which you’re pretty confident in the earnings outlook and where you believe you now have the pricing power, the wherewithal to actually go through this what looks to be a pretty slowing environment ahead of us.
– Is there a certain industry or industries that perhaps will not have to downward revise their earnings expectations to the same degree as some others?
– I think it’s magnitude what we would refer to. I think, collectively, most industries will have to revise down, some more than others. You’re seeing the pullback right now. In your opening comments, you were talking about what’s happening in energy and commodity– and the commodity space. So I do think you’ll start seeing more significant revisions there. I’m more interested in places where I think they’re more defensive. High growth– sorry, not high growth. Very, very profitable large cap tech.
I’m talking about the Microsofts and the Apples of the world. They should have probably more stability. Health care, we’re in an election year. And if memory serves me, in most election years, people are always — health care is controversial. They’re always talking about exorbitant drug price increases, and so on. This election year, because people are so focused on inflation and what’s happening with remnants of the virus in China, lockdowns, no one’s talking about health care. So health care earnings generally should be fine. And are relatively insulated in this backdrop.
So when we’re thinking about going into a slowdown we’re thinking about in portfolios as high grading your portfolio, finding companies where you’re more comfortable with the earnings outlook. And for a lot of these names, because they are growthier names, they’ve actually seen a fair amount of pain over the last 12 months. So we actually have some almost like downside protection because they’ve already been repriced lower.
– Damian, I understand after the first half of the year that we’ve had a lot of people probably feel this way. You call it a bit of a hangover period that we’re in right now. That actually gives me a bit of hope because eventually you recover from a hangover.
– I think so. I think, look, what got us into this, right? What got us into this period? It’s — we had extraordinary fiscal spending last year that supercharged consumer spending. We had a very, very accommodative Federal Reserve and central bankers globally. Last year, rates were 0 or 25 basis points and inflation was five a year ago last year. That was probably a bit too loose.
This year, the punchbowl has been taken away. The Federal Reserve has gone from 25 basis points to 175 now and more. All of these things are this, what you just referred to, Greg, this almost like this hangover effect. But this too will pass, right? What got us into this is likely what’s going to get us out. You’re already seeing evidence of the demand induced inflation start moderating. We can talk about companies that have reported so far. Bellwethers in the retail space. Target, a few weeks ago, was off 25% because it said it had too much capacity, too much inventories, and it hired too many people. Both those two things tell me that pricing power or the price of goods in the future are likely headed in the right direction as in lower.
And you know what’s happening in the energy space, that’s been one of the biggest contributors to inflation. That too looks to be taking at least a step lower. So I guess the idea that inflation can remain at these really elevated levels and the Federal Reserve will have to continue on this very hawkish path, continual rate rises. And this goes for the Bank of Canada and global central banks. I think some of that, the air out of that thesis is going to come out. And what that means is, markets can be comfortable that we’re not going to have these significant rate increases that are actually going to spike volatility, and so on.
– Damian, with all of that said, it is very fashionable right now. It seems particularly a few are involved in the social media world of people in the finance space to be bearish, and it’s easy to be bearish. It almost feels like contrarian not to be bearish in this market.
– Well, as — I’m not fashionable. So the easy thing is — I don’t think in that way, right? I think you want to be skating to where the puck is headed. And everyone right now is very, very bearish because in real time you’re seeing the economy slow. But if my outlook is somewhat directionally correct, in the next 12 months you should actually see this elevated level of rate increases start moderating.
In fact, it’s happened in the last two weeks actually, and I just put some numbers to that. They have expectations of where Fed funds will be in the future. So the Jan 2024 expectation a few weeks ago was between 3 and 3.5%. That’s what people thought the Fed funds rate would be. In 2 and 1/2 weeks, that’s gone down to 2.6. So what that’s telling you is that the market is pricing in that sometime next year we are actually going to have rate cuts. Those — that’s generally bullish.
So the way I’m looking at this is, given how much — you talked about how volatile these first six months are and how much pain is already being experienced coupled with that we’re probably — it might be a few quarters ahead, but we’re probably approaching peak tightening for the monetary space. I think markets are forward looking. And the outlook at least is– and given how much damage has been taken so far, the outlook, at least to me, looks to be quite positive. And particularly in stocks, we’re much more confident about earnings, and sales, and margins, and so on.
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