Earnings: The Other Shoe to Drop?

By Dr. JoAnne Feeney, Partner & Portfolio Manager

Investors remain on edge as interest rates climb, inflation remains stubbornly high, and recession is thought to be right around the corner. The first two are facts, the third is conjecture. As investors look for further clues regarding recession risks, attention has turned to third quarter corporate earnings reports and, more importantly, the outlooks companies are providing for business conditions for the rest of this year and even for 2023. Management teams have boots on the ground and may be able to see the shifts in demand that only appear with a lag in official statistics. As they bring that information to the public, we are seeing expectations and stock valuations adjust, sometimes dramatically. But another theme is emerging from earnings season, too: we are seeing signs in some parts of the market that investors have already priced even worse news into valuations, as our CIO, Chuck Lieberman wrote last week.

Earnings estimates have been coming down for the last several months, as analysts adjusted outlooks to weaker demand, higher costs, and ongoing supply chain constraints in various parts of the economy. Back in January, investors thought third quarter earnings would grow over 10% relative to 2021’s third quarter. More recently, earnings projections in 3Q were reduced to a dismal 1.5% year-over-year (and most of that is driven by the energy sector). But because those expectations have been reduced so much, better reports are being rewarded, even as those painting an even bleaker outlook are being punished further. Of the 20% of S&P 500 companies having reported thus far, 72% have beaten expectations. That sounds pretty good, but the average over the last five years had 77% of companies beating forecasts. The challenge for investors is to assess for which companies expectations have fallen enough.

In the technology sector, already pummeled by higher rates, inflation, and recession concerns, a new source of risk was introduced earlier this month when the U.S. government announced a ban on the export to China of certain advanced semiconductors and the tools needed to manufacture them. Those U.S. restrictions threaten to prevent US (and allied countries’) companies from selling their most sophisticated and profitable tools to China’s semiconductor manufacturers. The goal is to prevent or at least delay China’s access to the advanced chips that would enable it to achieve greater military capabilities. Because China had become a significant growth market as it attempted to build up its own semiconductor industry, this deals a blow to sales for advanced chip and equipment suppliers now and for many years to come. For some companies, this would knock about 20% off of revenues next year. Shares of the three major U.S. semiconductor equipment makers (LRCX, KLAC, and AMAT), already under pressure from concerns of a coming cyclical downturn, dropped by an average of 15% from October 7th through the 12th after the latest and most severe restrictions were announced.

This was the second announcement by the U.S. government along these lines, and shares had already traded lower since the summer on the heels of the first set of restrictions. So, when one of the big three U.S. equipment companies reported results last week and did indeed confirm that those restrictions would sharply reduce sales next year, the stock’s price was crushed. Um, no, wait. Shares surged higher by nearly 12% in the subsequent two days. It turns out that investors had already factored in the consequences of the new U.S. policy.

More importantly, not only is the U.S. imposing these severe export restrictions, it is also subsidizing the U.S. chip industry to build more fabrication facilities here at home. The European Union is doing the same. The threat that China may invade Taiwan has made many governments wary of reliance on Taiwan Semiconductor Manufacturing (TSM), the world’s largest contract manufacturer of chips. Those subsidies will increase manufacturing outside of China and so will help replace demand for the semi manufacturing tool sales lost out of China. This will only happen gradually, but it will happen.

Moreover, when last week one of the U.S. tool suppliers outlined ongoing strength from other customers and reminded investors that the world would still need many more memory, logic, and specialty chips for years to come (regardless of whether China could produce them), investors realized that longer term, these companies would still experience demand growth, once we get through 2023.

Investors really are forward looking, but they prefer to increase their investments in risky assets like equities when they think the worst news is out. We’ll learn a lot more about company outlooks over the next few weeks of earnings reports, so expect continued volatility, but “the worst” may already be factored in for some companies.

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