Earnings Outlook Matters During Rising Rate Cycles -T Gardner, CJ Lawrence Market Comment 2.15.22 – YouTube Video & Transcript

Terry Gardner, Jr.:

Hi, good evening everyone. It’s Terry Gardner from C.J. Lawrence coming to you on Tuesday, February 15th, from the C.J. Lawrence Global Headquarters here in Midtown Manhattan. I want to give you some perspective on the current state of the stock market and the economy, covering a couple of points. First off, we’re going to take a look at fourth-quarter 2021 earnings results, see how they’re coming in versus expectations. Number two, we want to summarize the macro backdrop for both the economy and the stock market. Number three, we want to share some work that we’ve done here at C.J. Lawrence regarding interest rate cycles and rising rate environments. And then fourth, let’s discuss a portfolio strategy for the next 12 to 18 months. First off with regard to earnings, which we’re close to the end of earning season, where companies report their results for the fourth quarter of 2021, 75% of the S&P 500 has reported to date and 78 of those companies have come in with positive surprises.

Terry Gardner, Jr.:

That sounds like a pretty good number. I would note that the last couple of quarters have seen positive surprise results come in north of 80%. Earnings are still coming in strong, but perhaps not quite as strong as they have in terms of upside surprise as the past couple of quarters, so something to note. After all the numbers are calculated, looking at forward estimates, the 2022 expectations for S and P earnings growth now stand at about 8.4% and at around 10.2% for 2023, so the earnings growth backdrop still looks pretty good. With regard to point number two, our discussion about the macro environment. I think we could kind of categorize it as somewhat unsettled, both the domestic and the global economies are recovering from the kind of COVID-depressed levels, and that’s a positive backdrop. At the same time, we’re facing rising inflation in labor, commodities, services and goods also resulting in rising interest rates in response to central bank desires to raise normalized interest rates in response to inflation and the desire to head off rising inflation.

Terry Gardner, Jr.:

We’re still seeing some lingering supply chain issues, which are inflationary and driving some continued bottlenecks in terms of freight flows and of course, and who knows where this will be tomorrow or the next day, but geopolitical tensions that we’re experiencing in Russia and Ukraine, with that crisis, unclear how that’s all going to end, but that always injects a level of worry into the market. One day it looks like things are easing. The next day, things are getting a little bit worse, so we’ll have to follow those events carefully. All of these events are important. All these market phenomena are important, but they all, in some way, directly or indirectly, tie into interest rates in the interest rate environment. With regard to point number three, we dusted off some of the work that we’ve done over the years here at C.J. Lawrence regarding interest rate cycles and rising rate cycles.

Terry Gardner, Jr.:

We’ve got a lot of it. I want to share a little bit some conclusions with you. We’ve looked at not only three-month T-bills cycles, which are largely tied closely to fed activity and the fed’s movement in the Fed funds target rate, but we wanted to take a look at the 10-year treasury. In particular, the rate of change in the 10-year treasury, because that does have an impact on market volatility. One of the things that we looked at going back to March of 2012, just to try to take a look at the last couple of cycles in the 10-year treasuries, is what happens when rates rise rapidly? We ran a 30-day rate of change analysis, and what happens is, you can see it clearly when rates spike, particularly at the 10-year treasury, stocks struggle, during that period, while that rate of change is accelerating.

Terry Gardner, Jr.:

It seems, by looking at the data, that once the rate of change, meaning rates today are some percentage higher than where they were 30 days ago when that starts to peak out around 25% and starts to come down, stocks start to calm down. In fact, we ran an analysis showing these seven peaking periods going back to 2012, and in the six months ensuing, after these rates of change have peaked, stocks did particularly well, with positive returns in each period. We thought that was noteworthy, and we’re starting to see peaking in that rate of change in the 10-year treasury, so that might be constructive. Of course, we’ve, for years, looked at treasury bill cycles. I’m going to put that aside for a second, but the conclusion of that work has always been that even during rising treasury bill cycles, stocks do particularly well.

Terry Gardner, Jr.:

We wanted to conduct that analysis using the 10-year Treasury bond to see at the longer end, which tends to be a little more inflation sensitive and market-driven, how those cycles resulted in stock performance. And the result was somewhat the same, whereby, stocks during periods where rates rose from a trough to a peak, on average, during those seven periods that we calculated, stocks rose 25%. Why is that? Because it seems to be in the market narrative that we hear often that rising rate environments are bad for stocks and certainly for PE multiples. We took a look at that phenomenon, as well. And really, what’s driving the performance in stocks is during these periods where rates are rising, earnings are also rising. In periods where rates are going up, so long as earnings stay on course, and earnings are growing, stocks can do particularly well.

Terry Gardner, Jr.:

Do PE multiples compress during these rising rate cycles? The market narrative is yes. You’ll hear regularly in the financial media that higher rates mean lower multiples. Our work suggests that the results are actually mixed. There are seven periods that we looked at where the 10 year moved over 150 basis points from trough to peak. During those periods, four of the seven saw PE multiples actually expand. Three of them saw a compression. It’s noteworthy, though, that what really drives longer-term performance and is what happens after the fed has been raising rates or after the 10 year has risen a certain amount. What happens to the economy afterward, if earnings continue to grow, stocks continue to perform. If the economy goes into a recession, all bets are off. Not a surprise there. So what are we watching as we go forward from an interest rate cycle perspective? Rising rates can still mean strong stock performance, but it’s what comes after.

Terry Gardner, Jr.:

Will the fed drive us to a point where the economy slows and we start to look at recession? That would be troublesome. But if the fed raises rates, PEs can hold in there. And if the economy can continue to perform and sales and earnings can continue to go up, stock prices can do well. That’s really the summary for today’s call. A couple of things that we would highlight with regard to our portfolio strategy. What we’re starting to really focus on is the durability of companies’ businesses. Durability is the new watchword. We like to see companies that can do well and drive a business regardless of the macro backdrop. Two, we’re looking for earnings that can grow faster than the market. Clearly, those are the companies that will kind of separate from the pack.

Terry Gardner, Jr.:

And then thirdly, we like the fact that we’re still starting to see the cyclical recovery, the economy’s growing at a good clip coming from COVID-depressed levels. But of course, we love secular growers, but if we can marry up secular growth with cyclical recovery, that’s a win-win and those stocks should outperform. That’s it for today. If you’ve got any questions or would like to see any of the data that fed into some of this narrative, please give me a ring at 212-888-6403, or drop me an email at tgardner@cjlawrence.com. Have a great rest of your week.