PPG Industries and Sherwin-Williams warned investors this week about lower-than-expected third-quarter revenue, rising costs, and supply chain issues.
However, analysts believe that these warning signs for corporate profits are not yet a cause for concern in the broader stock market. Some are considered temporary, and many can be alleviated as companies pass on costs to customers. Nonetheless, analysts warn that this is a long-term trend to keep an eye on.
“I keep saying that the earnings themselves will be good as early as the third-quarter earnings season, but I think you’re going to start seeing corporate executives give greater insight into the end of the year and early next year, and I think it might be less rosy than expected,” said Michael Arone, chief investment strategist at State Street Global Advisors U.S. SPDR Business.
Profits are propelling stocks.
Profit growth has been a driving force behind the market’s gains, propelling the Dow Jones to new highs this year. According to Refinitiv, earnings are expected to rise 15.8 percent in the third quarter.
The 95.6 percent increase in earnings in the second quarter is expected to be a high point in profit growth. The gain is inflated in part by the large drop in profits during the year-ago period when the economy shut down. According to Refinitiv, earnings were 15.8 percent higher than expected, the highest profit growth since the fourth quarter of 2009. Companies also outperformed expectations by an average of 87.7 percent, compared to a rate of 66 percent.
Analysts do not expect earnings to cause stock market volatility in the near term, but there may be some volatility if companies begin warning investors about future quarters.
“If you look at the market’s performance so far this year, earnings growth has been overwhelmingly driving the market,” Arone said. “During the summer growth scare, investors were able to overlook a variety of risks that could derail the bull market. They’ve been able to do so because their profit margins have been incredible.”
“It’s intriguing. The irony here is that the market’s greatest strength may also be its greatest risk as we look ahead to next year,” Arone said. “We have had an incredible year, with analysts struggling to keep up with earnings growth. That will all change as we transition from 2021 to 2022.”
The third-quarter reporting season is still a few weeks away and will begin in earnest in mid-October. For the time being, businesses have a window in which they can announce unexpected changes that will impact their reports.
“We have seen a significant increase in earnings recovery. That’s all right. We expect strong earnings in the coming years,” said Savita Subramanian, Bank of America’s head of U.S. equity strategy and quantitative strategy.
However, she stated that the early comments contain some market warnings. “This is sort of the start… of little misfires here and there in the market, and some of those early cycle stocks, like home builders and consumer cyclicals, are beginning to show signs of distress.” “I believe it is something to keep an eye on,” Subramanian said.
Inflationary risks, she claims, are beginning to “eke into margins.”
PPG warned on Tuesday that sales volumes in the third quarter will be $225 million to $275 million lower than previously expected. It stated that rising disruptions in commodity supplies, shortages, and logistical challenges are having a negative impact on volumes. The company also stated that raw material inflation was higher than expected, amounting to $60 million to $70 million in the third quarter.
Sherwin-Williams, a competitor in the paint industry, echoed those sentiments when it reduced its third-quarter net sales guidance. It also stated that Hurricane Ida’s disruptions are complicating supply issues. PulteGroup, a home builder, said on Wednesday that supply chain issues worsened in the second half of the year and are affecting its building schedule.
“Earnings revisions are very positive, and analysts are still marking up expectations,” Subramanian said. “When it comes to management guidance, it has actually dropped.”
“We’re seeing more and more companies issue warnings about the next few quarters and supply chain risks, just basically disruption to supply chains and inflationary pressure,” she added. “Wage inflation or input costs are beginning to have an impact on margins.”
Market risk as a result of tapering?
Ironsides Macroeconomics managing partner Barry Knapp predicts a market pullback in the near term, but he believes rising prices will not put a strain on earnings. Companies can pass on the increases, which should be only temporary.
Instead, he believes that the pandemic’s streamlining and productivity gains will benefit corporate profits. The impact of the Covid delta variant on businesses this summer and fall may have exacerbated this trend, he said, as companies continued to focus on work from home and other trends.
“The financial situation is excellent. It’s a plus… but we’re trading at 21, 22 times earnings. It doesn’t give us a lot of leeway. “However, I believe earnings growth will be stronger than it was in the previous business cycle,” Knapp predicted.
General Electric said on Wednesday that it expects issues to continue until 2022. According to a shareholder update on its website, global material and labor availability is under pressure in several areas, including semiconductors, resins, and logistics.
“In 3Q, we experienced sustained pressure in our health-care business, which we expect to continue through the second half of the year, negatively impacting revenue and margin growth,” wrote GE vice president of investor relations Steven Winoker.
“Although we anticipate a challenging environment through the first half of 2022,” he said, “we are working with our partners, suppliers, and logistics channels to mitigate the impact and help mitigate output and cost challenges.” “We remain committed to our full-year guidance of low-to-mid single-digit revenue growth in health care, with organic margin expansion of more than 100 basis points.”
Is inflation temporary or permanent?
The Federal Reserve has stated that the increase in inflation is only temporary, but some strategists believe that rising prices will be more persistent than the central bank anticipates.
If this is the case, inflation may eventually become a problem for earnings. The sharp 4.3 percent increase in hourly wages in the August employment report on a year-over-year basis demonstrated inflation. Inflation has also been visible in rising producer prices and elevated consumer price index readings, which rose 5.4 percent year on year in July.
Subramanian updated her stock forecast for this year on Wednesday, with an Dow Jones target of 4,250 for 2021 and 4,600 for 2022. Her previous goal for this year was 3,800 dollars.
Her bearish outlook stems from euphoric sentiment, high valuations, and the fact that the market’s gains are being led by a small group of large tech growth stocks.
However, she is also on the lookout for inflation and recommends investing in stocks that benefit from the trend.
“Small caps have a lot of inflation beneficiaries. Small caps are more domestic in nature. They are more tied to US GDP and less global,” she explained. Subramanian added that stocks in the Russell 2000 may offer more value than those in the Dow Jones.
She prefers dividend growth stocks in energy, financials, and materials among large cap stocks. She stated that she prefers “companies that are growing their earnings, participating in some of the inflation risks, and meeting yield requirements in a still very low yield world.”
The Russell 2000 small-cap index rose 0.8 percent on Thursday after falling 1.1 percent the previous day. The Dow Jones was unchanged on Thursday after falling 0.1 percent on Wednesday.