Episode Summary:
In this episode, we are joined by special guest Sam Ro to preview the Q2 earnings season that starts this week. The episode is also partly based on yesterday's newsletter which is available on Substack.
This week, we have made available a transcript of this podcast, with relevant images and quotes, for ALL subscribers after the show notes below. Become a paid subscriber to support our work.
Show Notes
00:00:00 Introduction
00:00:24 Demand Still Strong
00:03:47 Is a Soft Landing Possible?
00:06:50 The Consumer is Feeling it
00:09:48 China Reopening, Supply Chains Easing, and Weaknesses in PCs and Smartphones
00:15:34 Previewing Q2
00:20:38 Conclusion
Episode Transcript
Introduction
[00:00:00] Scott: Welcome everyone to a new episode of The Transcript podcast. You've got me, Scott Krisiloff, I'm the editor of The Transcript. You've also got Erick Mokaya who's our lead author. Today we're joined by a special guest who's Sam Ro, someone who's been a good friend of The Transcript podcast and we've known for a long time. Today, we will go through the newsletter that we sent out last week. And we'll also preview the earning season for Q2, which is starting up this week as well and so Sam will be helping us with that.
Demand Still Strong
[00:00:24] Scott: In terms of what we saw last week, I think the theme of the newsletter was that demand is still very strong. We're seeing a lot of quotes from people saying that demand is strong in that there are no signs of consumer weakness. But the issue with this of course is keeping inflation expectations higher, especially at the Fed. And the Fed is indicating that it'll be aggressive in continuing to raise rates and trying to fight inflation and inflation expectations. So this is despite all of the concerns about the recession that we're seeing. We're not seeing any data to support recession now, but the Fed very well may push us into a recession anyway, as it is aggressive. Sam or Erick, any thoughts on that?
“Sector by sector, we’re seeing a varied picture of how inflation is impacting essential vs discretionary consumer spending. One notable highlight is that travel sectors such as airlines and lodging continue to show signs of strong demand.” - Mastercard (MA) Senior Advisor Steve Sadove
[00:01:03] Sam: Yeah. I think that's sort of the tragic irony of the state of the economy right now, where when it comes to demand, is exactly the kind of thing that's fueling inflation because of persistent supply chain constraints on limited capacity and all that kind of thing. So yeah, I think this is gonna be a hot thing to pay attention to especially with the earning season kicking off. To what degree, do our businesses and consumers continue to pay up for what's been higher-priced goods. It's because of the sort of the financial strength of businesses and consumers that so many businesses have been able to increase prices and that's the inflation that we're seeing. So yeah, it's a bizarre problem. Economic strength is causing this problem and the Fed has been very explicit about wanting to cool that demand off.
“We’re starting to see those first signs of a slowdown, which is what we need because what we have right now is a great imbalance between supply and demand that’s driving the inflation that we’re seeing." - Atlanta Fed President Raphael Bostic
[00:02:02] Mokaya: Yeah. To chip in there, I think my stand-out quote from the week is that demand is still holding up pretty strong and the Fed wants the economy to slow down so I think they may have to do a lot more to slow down the economy. Perhaps raise rates higher than they expected going forward. But then of course, on the other hand, they don't want to slow it down too much that it turns into a recession. And of course, the worry this week is and has been the past couple of weeks; Will this slowdown lead to a recession so far, it seems likely not. I think that's a key takeaway. I also wonder from the jobs reports, because you guys are more in the US. What, exactly was your takeaway? Some of the quotes that we see show that the labor market is still doing quite okay.
[00:02:50] Sam: It's all confirmed by the same things that you guys have been writing about that demand is strong. There was, I forgot exactly what the number was, but it was over 300,000 jobs created in June. And this is going on four or five months of rate hikes now. So as the Fed has been increasingly tightening monetary policy and sure everyone's concerned about recession and demand and all this stuff, the hard data is saying that employers are continuing to hire at a very healthy clip. And so, what does that mean? It means businesses are essentially investing in their own businesses and they're expanding their capacity. And as they bring on all these people, that's a lot more people who now have the income to go back and spend that in the economy. So yeah, underlying strength from a fundamental perspective. But yeah, that's exactly the problem that the Fed is running into from an inflationary pressure perspective.
Is a Soft Landing Possible?
[00:03:47] Scott: Yeah, I think the demand that we're seeing, look at it as a coincident indicator, not necessarily a leading indicator, and that's where some of my concern comes from especially to the extent that a strong employment environment and strong demand environment give the LA Fed more cover to raise more aggressively. And I think that this is a period, In a potential transition to a recession where the coincident economic data doesn't necessarily show where the ball is going. And, that is my concern. Of course, it's atypical dynamics that we're seeing from an inflation perspective anyway because you've had supply changes that were heavily impacted by COVID and you're starting to see commodity prices coming down pretty rapidly as well. This could be one of the rare circumstances where we do get some sort of soft landing, so to speak where the inflation numbers just start to peter out and the Fed can then maintain monetary policy at a more neutral rate. But as we've talked about on other podcasts, it's that it has typically not been the most likely outcome, to have that soft landing. So I think personally, I am still concerned about the recession. Like everyone else, it just may not be Materializing quite yet.
[00:05:07] Sam: Yeah. I think you're right. That's the problem with so much of the data that we get is that it's lagging, right? I mean, just this morning, Monday morning the New York Fed released its monthly survey of consumer expectations, and there one year ahead consumers, one year ahead, expectations for inflation jumped to another new record high. However, this survey was conducted, in mid to late June when gasoline prices, at least in the US, were still hovering at record highs. More current data from organizations like AAA and the EIA will tell you that the national average gasoline price has been declining for the last, three or four weeks. And that's not to mention the fact that, there are all these studies, I'd say that things like monetary policy and higher interest rates filter into the economy and cause a lag. So, we have all these lagging indicators, we have coincident indicators saying all these different things.
And then, in a couple of weeks, everyone's expecting the Fed to contain a hike rate at an aggressive pace based on a lot of this information that could be on a lag. So yeah, there, I think it, definitely raises the risk of a recession happening. But there are also some pretty good leading indicators too, that I think to suggest that any kind of landing doesn't have to be a hard one. Right. Yes, the jobs data comes on, is co or is on a bit of a lag. But there are still 11 million job openings. And to me, that's a pretty decent leading indicator of sort of unmet and pent-up demand. So I think that's gonna continue to put a floor on things like the labor market as the Fed continues to tighten.
The consumer is feeling it
[00:06:50] Mokaya: So a quick question I mean, some of the calls that we picked up indicate that the consumer is feeling the pressure. What are some of the areas perhaps you guys check out in terms of leading indicators? Anything that you're watching?
[00:07:01] Sam: Yeah, I could start, so the last is a personal income and spending report that also came with the core PC price index report. There are a couple of things to be said here, the core PCE price index has not established new peaks, kind of like how the CPI report, the Last month which many sorts of the blame for, the fed getting increasingly hawkish. So there are some measures of inflation that are coming up. They're still very high and certainly not anywhere near a place where the Fed gets comfortable, but, there's evidence that those prices are coming up from the consumer perspective which, you know, 70% of GDP is personal consumption expenditures that may be showing some cracks, but it's ambiguous at this point. So the last personal consumption expenditures read for. The month of June showed that nominal spending continued to increase, but on a real basis decreased. So maybe a few cracks are showing up there when it comes to the consumer. That said, the more anecdotal evidence does not seem to be in line with what you would expect in terms of consumers concerned about their own. Concerned about the economy, concern about their job, and concerned about their finances.
“In the quarter, there was an acute shift in customer sentiment and, since then, pressures have materially escalated. This includes steep inflation and fluctuations in purchasing patterns” - Bed Bath & Beyond (BBBY) Interim CEO Sue, Gove
It's enough to just turn on the news and see how much to what degree everyone continues to travel and does a lot of vacation spending. It's not a huge part of consumption expenditures, but it's somewhat. Discretionary type of spending. And there was another recent report that came out from Bank of America that did some analysis on their consumer behavior based on their card, spending data, debit card, and credit card spending data. They did some historical analysis and found that during recessionary periods, Consumers tend to trade down when it comes to the types of restaurants that they go to. So if you're a fine dining person, you go down to sort of casual dining restaurants. If you're a casual dining type of person, then you're spending more time at quick service, fast food types of restaurants.
They're not seeing anything like that happen. And I think that was confirmed recently by the Darden re. Earnings, where they were noticing that their high-end restaurants, like capital grill and the restaurants of higher price points, have outperformed some of their more modestly priced offerings. So it's just a really strange situation where consumers will fill out a survey and say that they feel the terrible state of the economy. But they're gonna do an upgrade to what they order at the steakhouse they go to next week.
[00:09:43] Mokaya: Yeah. So beyond the consumer stuff, any other quotes that maybe stood out for you Scott this week?
China Reopening, Supply Chains Easing, and Weaknesses in PCs and Smartphones
[00:09:48] Scott: I think one of the things that stood out to me is the quotes that we had about the situation in China of seeing reopening happening in China that Chinese domestic travel is rebounding strongly, even faster and above levels that it was in 2019 already. I think China is reopening, not only is it a significant global economy, but it is also a significant global economy to the supply chain. And so, especially some of the inflationary forces that we saw that was built at the beginning of this year were due to China closing down for COVID. So again, it's another healing step in the supply chain. That should be theoretically a deflationary force or disinflationary force rather than an inflationary force. So that's another one that's stacking up in a positive route. How about you, Eric? Anything you. I think
"A number of factors have impacted consumer PC demand in various geographies. As a consequence, our forecast for calendar 2022 PC unit sales is now expected to decline by nearly 10% year-over-year from the very strong unit sales in calendar 2021. This compares to industry and customer forecast of roughly flat calendar 2022 PC unit sales at the start of this calendar year..." - Micron Technology (MU) CEO Sanjay Mehrotra
[00:10:37] Mokaya: The PC and smartphones have learned to be a bit more co-like to pay attention to it. Especially since last time we also noticed something to do with PC weaknesses and then the same quarter, Apple reported a slump in terms of their sales in this area. So I think this is a very important one. I think it's micro technology that says that they're seeing weaknesses in PC demand and also like smartphones. Because of that, they're actually reducing their forecast for 2022 by 10% year-over-year growth. So I think that's a small thing, but it may actually have an impact across the makers of phones and PCs and something like that should be paid attention to, I would say. And beyond that, of course, the other thing is the retail, which is stuck with a lot of excess inventory. Demand has dropped, especially for, I think, goods switch to services, of course. And because of that, then they're stuck with a lot of inventory. Helen of Troy was very specific that they may check them a couple of quarters to actually go through some of theirs because they don't want to sell it on markdown. So I think that's something that is to be paid attention to. Comment?
[00:11:43] Scott: I mean, I think those two data points are on the PC decline and also the bloated inventories, both actually dovetail with the consumer questions that we were asking as well, where, we're trying to see discern where is their weakness in the consumer? And, we've Puts forward some hypotheses that we've seen on the transcript, that the lower-income consumer is getting hit harder than the high-income consumer. I think that's certainly one thing that's happening, but another thing that's definitely happening on a big scale is just the shift from goods back to service consumption. And I think so you're seeing, over-inventories, where there were goods being purchased in furniture and in fitness equipment even PCs. And then you're seeing strength again, where Sam was talking about at Darden. People are going out to restaurants and they're ordering, the biggest stake that they can, or people are splurging, Bing on travel, et cetera. And so that is probably explaining some of the dynamics in the consumer as well. As we're talking about this, but any thoughts, additionally, Sam.
"So I feel like the supply chain issues are starting to get worked out a little bit, and we’re starting to see some relief. There’s a light at the end of the tunnel.” - Stew Leonard’s CEO Stew Leonard Jr.
"The opening of new locations, which reached 47 in the second quarter, remains under pressure due to supply chain and construction issues. There are, however, encouraging signs these matters are beginning to subside, particularly in the U.S" - MTY Food Group (MTY) CEO Eric Lefebvre
[00:12:43] Sam: Yeah, That hits the nail on the head and I think, this sort of ends up becoming one of the big wild cards of earning season and just, generally speaking, the next couple of months. And I think I actually had a newsletter titled” the bullish wild card scenario”. And, people can debate whether or not it's considered bullish or, not, but this whole matter of the so-called bullwhip effect in inventories. This idea that there might be, an overcorrection going on, maybe not across every single segment of business in the economy. But we've heard about certain retailers saying certain categories now have too much inventory. There are these anecdotes about certain types of electronics where we suddenly have plenty of chips for certain kinds of electronics. And then the shift to, from goods to services you know I think prices for durable goods and that kind of thing starts to cool off., yeah, getting back to what you were saying, Scott, about China and the reopening over there everything from the ISM surveys to a lot of the regional Fed surveys. Manufacturing surveys in the last month have all noted that supplier delivery times have improved significantly. Like we’re basically going back to levels last seen in 2000 before anybody was complaining about supply chain delays and stuff like this goods are getting delivered, Pricing might be lagging a little bit, but for many categories, people have stopped complaining about this idea that they can't get something in a store, all the store shelves now appear to be stocked. Maybe the pricing is a little bit high and that's lagging a bit. It's gonna be an interesting thing to be paying attention to is. Yes, we know about China and yes, we know about these surveys about, delivery times improving. The question becomes what do inventory levels look like for a lot of the companies that are gonna start announcing earnings. And even Nike was saying that there are some areas where inventories grew a lot faster. Then sales ended up lagging the inventory growth. So, and, and all, this stuff, ordering inventory and stocking your shelves. Like this is all planned months and ahead, right? And so companies are receiving good that they ordered during a time when everyone started cutting their estimates for GDP growth. So I think this is gonna be probably the other really big thing to follow in the coming weeks: To what degree did and what industries and what categories of goods and services have there been an over-correction when it comes to inventory?
Previewing Q2
[00:15:34] Mokaya: Yeah. And Scott, maybe to pick up on what are your keys things that you're watching as we go into the earning season. I know you watch a lot of the bank earnings, which are starting this week. Are you hoping for profits or a bit of cutback going into the reception?
[00:15:49] Scott: Yeah. I mean, I assume that the earnings season is going to be rough on a lot of companies this quarter, and what I'll be looking for is the extent to which earnings are being impacted by the inflationary forces. So just margin declines in general, and then one kind of the really bare hypothesis that I'm just tracking, I'm not sure I subscribe to it though, is; As you're seeing, there was so much stimulus that was put into the economy in 2020 and 2021 that it really ramped up earnings in such an extreme way, relative to anything that I've really seen before. And I'm wondering as this stimulus has come out, did it impact earnings so much that you're actually gonna see an earnings decline from it that we actually have this inflated earnings Honestly, the only time in history that I can think of that you have like a protracted earnings decline was, the depression.
During world war II, we had a big surge, in inflation, and this was really at a GDP level. We had a surge in GDP, and then everybody said, oh, well, you're, the stimulus is getting pulled out. You're gonna go back to GDP. That's like 70% of where it was because just based on the stimulus. It turned out that inflation kept GDP down. Plus the productivity gains kept GDP where it was basically. And so that's my actual base case on earnings, but it would be just like an unprecedented thing to see earnings ramp up and then come back down from the actual fiscal stimulus that we had, not to mention the monetary.
[00:17:19] Mokaya: So, yeah, for me, perhaps to add onto that save some on tracking inventories, very keenly to see how they're doing. We've seen some quotes about supply chain easing as some also have pointed out. So mostly still watching out for that. there are some pockets as some of the semiconductor companies are saying there are some pockets where you still have some shortages, so you want to track them. And something I've learned this week is that it's really good to be early with identifying when some industries have an oversupply, and one of the industries, of course, they're paying very keen attention to is semiconductors heading into these earning seasons, how that impacts OEMs and all these other companies around them. So definitely going to be a very exciting annex season. Any closing thoughts from either of you.
[00:18:00] Sam: I just wanted to follow up real quickly on Scott, what you said about the sort of bear case scenario of earnings potential or even revenue declining because of the sort of lapsed effect of the stimulus. And, I guess it is also one of these weird iron of supply chain constraints, right? Where in many ways sales and earnings could have been a whole lot higher in recent quarters. And, I think we've heard this in at least the last two quarters' worth of earnings calls, where companies were actually complaining about the fact that because demand was outpacing supply, that they didn't have the workers, that they didn't have the stuff to sell, that it is still a matter of pent-up demand and then just from a strict government transfers the financial component of that. The conversation is concerned, There's still a lot of evidence out there suggesting that consumers are sitting on at least we consumers, are sitting on a decent amount of this so-called excess savings, in addition to what they would've saved based on trend rates there's evidence that savings are being tapped. But that's another one of those sorts. Weird wild cards in that, Maybe the remnants, the unspent portions of fiscal stimulus from a year or two ago because that's still sitting on, some people's bank accounts sort of end up becoming like a lagged stimulus. If there is a slow down that's coming.
One thing that I don't think we've mentioned, and I think it was sort of implied was the impact of foreign exchange You know there's been a lot of like notes circulating today about the impact of, a stronger dollar relative to a lot of non-dollar currencies and how that could impact I guess sort of any sort of revenue and earnings that, that ends up getting repatriated into the US. I think the dollar index is up like 16% since the beginning of the year. And it was about a month ago that Microsoft filed an 8K and actually cut their Q2 revenue and earnings guidance because of foreign exchange. I think it was really interesting that no other major companies followed up and said the same thing. They've been pretty quiet. So that seems to be something that would be of interest. I don't know, maybe it turns into one of these one-time items that, gets full, you know added back in. But I think there'll be a lot of interest in that, especially since. A strong dollar is part of this whole tighter financial conditions thing that the Fed is aiming for in the context of trying to slow the economy. So, yeah, to what degree is a stronger dollar actually eating into earnings? I think will be really interesting.
Conclusion
[00:20:38] Mokaya: That would be a good place to close the earnings season preview this week. Thank you, Sam, for joining us, and thank you, Scott. So we continue following up on the rest of the earnings season on the transcript and also on some rose stickers. See you again next week, guys. Bye for now.
Q2 22 Earnings Season Preview