What First Quarter Earnings Reports Revealed About the Economy

Stock and bond markets are priced for an extremely optimistic outcome, but first-quarter earnings and recent economic data point to a different future.

The futures markets indicate investors expect the Federal Reserve will expand the money supply and reduce interest rates rapidly starting this summer. Inflation is expected to retreat to the Fed’s 2% target without a recession or significant decline in earnings. Yet, S&P 500 earnings for the first quarter were more than 5% lower than a year earlier. Problems continued in sectors that had troubles in 2022, such as technology, real estate, and others, and the effects of last year’s rapid tightening of monetary policy spread through to additional sectors.

Though the well-publicized bank failures didn’t occur until after the quarter ended, financial firms and banks had significant difficulties during the first quarter and weren’t optimistic about the rest of the year. A number of companies reported that inflation remained a problem, including widespread pressure to pay higher wages.

Higher compensation reduces profit margins or causes firms to increase prices, maintaining a floor on inflation. In the fourth quarter, technology companies made headlines with a large number of layoffs.

They continued layoffs in the first quarter and were joined by companies in a number of other sectors. In their earnings calls, many firms were careful to reduce expectations for the second quarter and the rest of 2023. They reported sales were slowing and inventories were increasing.

The strongest sectors in the first quarter were companies that sell directly to consumers, though the strength wasn’t uniform. Consumer discretionary companies reported that the weakness of 2022 persisted into 2023. Consumer staples companies were able to raise prices for their products, passing higher costs to customers and maintaining profit margins. But their sales volumes declined. A number of services firms, especially those in travel and hospitality, reported strong demand and the ability to raise prices.

Most banks said they have concerns about the economy for the rest of the year. They increased loan loss reserves and are tightening standards for making new loans. Those actions should reduce economic growth. The overall picture painted by first-quarter earnings is the economy continued to grow but at a lower rate.

The weaknesses that developed during 2022 remained and spread to other sectors. Most firms anticipate business will become worse before it improves. Inflation isn’t as much of a problem as in early 2022, but businesses still are paying higher prices for both supplies and labor.

Other data, which I review each week in Bob’s Journal, indicate growth is solid but unspectacular and uneven. The labor market weakened a bit. But it is strong enough to keep unemployment low and wage increases above the average of the last two decades. Wage growth needs to decline significantly for inflation to fall to the Fed’s target.

The economy is weak enough that the Fed doesn’t have to tighten the money supply further. But the economy is too strong and there’s too much inflationary pressure for the Fed to reverse its policy and expand the money supply the way markets anticipate. Stocks and bonds present substantial risks to investors.

They are priced for a very optimistic scenario that includes the Fed rapidly easing monetary policy soon, profit margins staying near the record high levels of the last few years, and earnings continuing to grow at a high rate. Keep in mind that stock buybacks are declining and are likely to decline more.

That removes a major support of stock prices. Retail investors are the major players in the stock markets now. Be sure all your portfolio positions have solid margins of safety, and you won’t find much of a margin of safety in the stock indexes.