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Finally – we can talk about something besides Russia, Rates, and Inflation.

Earnings season.

Although all these underlying macro components will all affect earnings, it’s nice to see sell-side reports talk about specific companies again.

When there are massive changing tides, it is always important to get the big picture right. A rising tide lifts all ships, but I want to pick the fastest ship.

The stock-junky in me craves it.

There will be no shortage of dramatics as this earnings season is going to be one of the most interesting since the start of Covid.

We’ve got a lot of moving pieces in the background, but at the end of the day – the best way to get a pulse on the market is the health of its individual constituents. We’re talking about the companies on the ground employing real people and selling real products.

This is going to be a good one.

This week, in <5 minutes, we’ll cover Q1 earnings expectations:

• Global Backdrop 👉 Setting the table

• Housing 👉 XHB down 26% YTD

• Semiconductor Industry 👉 Not a bull in sight

• Financials 👉 Rising rates but concerns of recession mounting

• Commodities 👉 Still room to run?

• Consumer Staples 👉 Need vs. want

• Megacap Tech 👉 Still a safe haven?

Let’s get started!

1. Global Backdrop 👉 Setting the table

In fed funds futures, the market is now pricing in about 270 basis points of tightening for 2022, topping the 250 seen in 1994, with expectations now for the rate to hit 3% by March 2023, according to Deutsche Bank. This is all in order to combat inflation that we haven’t seen in a very very long time. This is something we have read about and something we know.

What we need to figure out is what to expect going forward. So the three most important questions right now are: just how long will this elevated inflation last, what will be the timing of the rate hike cycle, and will the fed be able to achieve a soft landing?

The recent inflationary reading of 8.5% YoY CPI in March of 2022 is the highest since December 1981, when it was 7.9%.

If we look at the component breakdown, inflation is pretty widespread across all goods so it’s not easy to blame one component or another. However, a real standout was the impact that energy has had from being a detractor at the start of Covid to a large contributor during the economic reopening and war.

When trying to figure out what to look out for during earnings season, I find it helpful to break it down by industry when trying to think about the push/pull pressures. For the purpose of this newsletter, we’ll view some (not all) of the industries that we’re looking at that will be affected by the current macro backdrop.

Time for a rapid round.

Under the Radar

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2. Housing 👉 XHB down 26% YTD

Housing is one at the perfect intersection of everything going on – Materials, rates, covid, labour, etc…

Bull Side

• The overall trend of WFH has created the need for more space when it comes to residential housing

• Supply build-out in many cities has not kept up with demand

• Historically low interest rates have driven house prices to all-time highs

Bear Side

• Interest rates are going up. In my piece a couple of weeks ago on housing, I talked about how an increase in interest rates dampens demand. The average house buyer right now is not buying the purchase price, they are buying the monthly payments. Increasing mortgage rates increase the monthly payments, lowering demand.

• In the case of the increasing price of everything – the raw material components of new house builds are directly impacted. We remember back when lumber futures were spiking, but this further impacts all raw materials across the entire build of new units.

• On top of this, we’ve also heard about how tight the recent labour market is as a result of wage inflation, adding to the increasing cost of new builds.

Takeaway: Housing has been too hot for too long. I think the damage has mostly been done, but we could see some further weakness in the homebuilder’s index (XHB). We are approaching a drastic demand pullback because rates are spiking higher:

Before we continue, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel!

3. Financials 👉 Rising rates but concerns of recession mounting

Financial stocks are typically seen as temperature gauges of the overall economy, as the economy expands, lending activity from banks increases. However, an increase in rates to cool the economy during a contraction also increases the margins at the banks.

Bull side

• Banks can perform well as defensives due to an increase in profit margins when rates rise to cool inflation.

• As a lot of investors are rotating away from growth and into value, banks are a large beneficiary of this.

Bear Side

• If you believe a recession is in the cards, a retreat in overall economic activity still hurts banks, as they are not fully insulated.

Takeaway: The value trade is in vogue. You can’t buy anything that doesn’t have solid operating income and banks have this in spades.

I own JPMorgan, Morgan Stanley, Manulife, and RBC in my portfolio.

4. Semiconductor Industry 👉 Not a bull in sight

Semiconductors power the intersection of physical and digital advancements. For a quick 3-pager, I found this thread to be an excellent summary:

Bull side

• 5G and datacentre buildout continue to be long-term secular trends in the global theme of digital transformation

Bear Side

• The key concern right now for semis is the timing and magnitude of an eventual inventory correction. Most investors agree that semis are over shipping end-demand today with varying degrees of inventory build across the channel. This will lead to revenue contraction (ex-memory) in CY23.

• Supply chain woes galore. Semis rely heavily on the supply chain across the different value-add components between raw materials and end product.

Takeaway: Semis were hit in tandem with growth names on the concern over rising rates, but had a double-whammy by also being impacted by inventory buildups, supply chain problems, and softening end demand. I’d take a cautious approach here.

I own Analog Devices in my portfolio.

5. Commodities 👉 Still room to run?

Without a doubt – it has been the year of commodities. Oil has roared back to life and more broad-based commodities like metals & materials are the main beneficiaries of the increased price of (almost) everything.

Bull side

• ESGers got a complete smackdown. The reality is that there is just not enough capacity built out to fill the energy demands of the modern society and Oil & Gas is having its day. The amount of free cash flow these companies are now generating with WTI north of $100 is massive. On top of that we have a war and a lack of capex build-out over the last decade, giving those “last men standing” a solid moat.

• On the materials side – we’ve covered the spike in commodities in several pieces. With supply chains still handcuffed and China undergoing another wave of shutdowns, it’s hard to see light at the end of the tunnel.

Bear Side

• The only downside to this trade is what is already “priced in”. These names have seen a massive run, but I do think they have more to go as we’ll be in a higher-for-longer environment for both rates and inflation than people expect.

Takeaway: Stay long Oil – particularly refiners (look at the crack spread).

I missed the trade and I am not chasing it here. The “easy” money has been made in my opinion and I’ve gotten myself in trouble in the past chasing trends late in the game.

6. Consumer Staples 👉 Need vs. want

When looking at the consumer goods category, you can broadly classify these as discretionary (want) vs. Staples (need). The idea is that when the average consumer sees an increase in disposable income, they have more cash available to spend on discretionary goods.

Bull side

• As stimulus checks run out and the possibility of a recession looms, capital flows on a relative basis to a lot of these consumer staples companies.

• Staples companies also have the general characteristics of low growth with an emphasis on profitability which, again, is favourable in this growth/value rotation everyone’s talking about.

Bear Side

• The inflation of all commodities is leading to an increase in inputs costs which could squeeze margins over the shorter term.

Takeaway: You don’t always need to perform rocket surgery when going through stock selection. Sometimes you need to stick with the tried and true. Here’s some food for thought:

I have been long and strong Home Depot in my portfolio for quite a while.

7. Megacap Tech 👉 Still a safe haven?

Megacap tech stocks have traditionally been seen as a safe haven and are starting to act more and more like defensive. However, there is definitely bifurcation when looking at the names because they are not all alike. For instance, Google and FB are internet and media companies, Microsoft is a software company, Apple and Tesla are hardware companies, and Amazon is an everything (ecommmerce, cloud, ad) company.

Bull side

• On an EV/EBITDA basis, you have Microsoft trading at the same multiple as Costco, and Google trading at the HALF the multiple (11x) as Coca-Cola (22x). These megacaps are now steeply discounted considering profitability and growth rates.

Bear Side

• Rates & Rotation. The mantra, “Don’t fight the fed” is extremely relevant when it comes to these tech names as they seemingly just cannot catch a bid in a rising rate environment. Even as the growth/value rotation takes hold, there comes a point where some of these tech names actually become value names!

Takeaway: Amongst the technology names, we saw NFLX get destroyed after a slowing subscriber growth, but we saw solid results from the software division at IBM. I think software has been absolutely crushed here, and as long as you can point to a reasonable EV/EBITDA multiple amongst the more GARP-y names, it’s safe to pick away.

I own Google, Amazon, Apple, and Microsoft.

Wrapping Up…

There are ALOT of moving pieces to this earnings period. You can start with the big picture, but I believe right now is about as good a time as any to be a stock picker in this volatility.

Start with top-down, but the bottoms-up matters ALOT now – just ask Netflix.

Until next time. Always Yours. Incessantly Chasing ROI,

-Genevieve Roch-Decter, CFA

P.S. Have you subscribed to our *NEW* CRYPTO NEWSLETTER?

What else we Grittin’ On?

BOA. Bank of America reported a 12% drop in first-quarter profit. It's been an underwhelming earnings season for big banks.

TESLA 4X. Cathie Wood's Ark sees Tesla shares more than quadrupling by 2026. With a target pr $4,600.

CHIPOTLE FUND. Chipotle has launched a $50M venture capital fund to invest in tech startups. It aims to help run its restaurants better and improve the customer experience.

CAMPUS HOUSING. Blackstone makes a $13B bet on campus housing acquisition. The company agreed to buy student-housing owner American Campus Communities Inc.

NATGAS. US natural gas surged to a 13-year high this week. It topped $8 briefly for the first time since 2008.

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