The recent US earnings season may have been cheering for some investors, as several results came in better than expected. David Segera, chief US market strategist at Morningstar Research, discusses whether those results are sustainable as the economic clouds darken.
Greg Bonnell: There was no shortage of catalysts in the markets this week. We regularly receive earnings releases from some of the biggest companies on Wall Street. We have concerns about the health of US regional banks. Of course, we also have central bank decisions. Joining us now is Morningstar Research’s Chief US Market Strategist, David Segara. David, great to have you back on the show. We have a lot to talk about. Why don’t we talk about earnings season? We are now in the thick of it. What have we seen so far?
David Seger: Well, actually, my big point to start with is that companies are actually giving relatively conservative or something like guidance at the beginning of the year in anticipation of an economic slowdown. Of course, that didn’t happen. So the overall return is pretty easy to meet or beat at this point.
So when I look at the start of the earnings season, it started with the big banks. They were generally in better condition than expected, and their guidance was also better than expected. The real move for me is the increase in the loan loss reserve. But they increased those loan loss reserves only slightly above the historical average. So what that tells me is that the big banks, they’re preparing for a moderate or mild recession, but they’re not really looking for a spike in defaults or bankruptcies.
Now, look at the big tech, often, better than expected. They offered some gentle guidance, but that guidance was better than a lot of people feared. I think the exit from big tech is still softening the economy, but it’s not softening at a rapid rate. This week, I’m starting to shift my focus to what I call real economic stocks, industrial companies. I spoke to our industry analyst yesterday and I like his take. He quoted me saying that truth is better than perception. And he breaks these into two different cycles. So again, there are long business cycle stocks, and what he’s looking at is, therefore, the type of companies that have long lead times, like aeronautics and automation, that are still doing well.
But what he noticed was that he began to see weakness in stocks with a short business cycle, which is a quick turnaround between production and sales. So I think that indicates that the economy is starting to stagnate or soften.
Greg Bonnell: If we get this slowdown that we’ve been talking about for a long time, and executives are commenting when they give earnings, the path forward may be a little more difficult, and it’s going to be a well-telegraphed one. . I mean, is this really market-type fully priced in that we keep saying recession, recession, recession?
David Seger: Well, in our view, we think US stocks as a group are generally undervalued. Again, we cover over 700 stocks that trade on US exchanges. Also, we compare the intrinsic value determined by our analysis team to where those stocks are in the market. So while we think stocks are generally undervalued, I think we’re looking at a relatively rough road ahead for the next couple of quarters.
So we think the economy will stagnate in the second quarter. In fact, we expect a zero GDP print in the second quarter, a slight contraction, perhaps under a 1% contraction in the third, and then a very slow recovery starting in the fourth quarter. So, of course, that will put pressure on earnings for the next two quarters. I think you can see some negative market sentiment.
Now,If you look at the S&P 500, we´re still close to the top of the trading range that we´ve been very high since last fall. To break that ceiling, I don’t think it will be until later this year. I think the markets will look for the leading economic indicators to actually come around and break out of the bottom but then start moving up again.
Greg Bonnell: Of course, the big story in the markets over the past several weeks has, of course, been the turmoil we’ve seen in US regional banks. There is a lot of debate about whether this is more specific, unique to these banks, or whether we have a different issue on our hands. How should we view regional banks now?
David Seger: Well, our take on regional banks is that they are stressed but not broken. When I look at our coverage of regional banks, First Republic ( OTCPK:FRCB ) is the only one where we really question its viability as a going concern. In fact, we cut the fair value of that stock down to $3 a share, I believe, down to 0 in March.
But from a fundamental point of view, the net interest income limits, they are compressed, but we are incorporating it into our valuation models. In fact, we forecast that revenue would have already peaked in the fourth quarter of last year. We think they will continue to decline later this year and not break out until the fourth quarter or even early next year before starting a slow recovery.
But overall, for long-term investors, we think these banks will earn the cost of capital or more. So, yes, there may be some other bank failures, but in the regional banks that we cover, we don’t see that. And, in fact, I think the market is, to some extent, overreacting to these short-term pressures and, in many cases, may have pushed many of these stocks too far.
If we still see this negative sentiment in the markets, the share prices of those regions will be pushed down further, and indeed the central government or central bank will have to try and help with some new program. To reduce that pressure.
Greg Bonnell: Of course, when you’re talking about the First Republic there, the stakes are listed based on what you’ve seen. When it comes to that name, it’s not really going to bother anymore, except that its assets have actually been snapped up by JP Morgan (JPM).
David Seger: Exactly. So, officially, I believe it was received by the FDIC. JP Morgan then bought the properties and took the deposits with them. So depositors out there, they will be perfected at the end of the day.
Greg Bonnell: When it comes to bigger macro concerns, well, we’ve talked about earnings, we’ve talked about regional bank stress. Of course, we still have central banks. In this country, we are in a conditional suspension. We have been for some time. People trying to figure out what the world’s most influential central bank, the US Federal Reserve, is going to do. How do we see the path forward for them?
David Seger: At this point, I think everyone really expects the Fed and the US to be together. I think the central bank is going to pause after this hike. In fact, it will be a matter of how long they can keep rates high until the economy softens enough and inflation drops enough for them to start cutting rates. In our view, inflation will continue to moderate throughout the year. Again, we expect the economy to soften, perhaps bottoming out in the third quarter. So we think this combination will give the central bank the ability to cut rates. We think the first rate cut will be in December this year.
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