CICC: Where is the US recession "at"

Overall Trend: Second-quarter profits are not bad; increased revenue and reduced costs jointly improve net profit margin and ROE

S&P 500 earnings accelerate, while Nasdaq decelerates. In comparable terms, S&P 500 second-quarter EPS increased by 11% year-on-year, accelerating from 6% in the first quarter, and did not experience a significant contraction as feared by the market. In comparison, the EPS of the Nasdaq index, which is concentrated in growth stocks, fell from 28% in the first quarter to 13%, which is not bad, but the significant decline in growth rate explains some investors' concerns that low growth cannot support high valuations. The proportion of companies exceeding expectations remained basically the same (78% in the second quarter vs. 79% in the first quarter), while the magnitude of exceeding expectations decreased from 7.9% to 3.5%, reflecting that investors' previous expectations may have been overly optimistic.

Accelerated revenue and reduced costs improve net profit margin. On the revenue side, the non-financial revenue growth rate of the S&P 500 in the second quarter increased from 4.4% in the first quarter to 5.8%, indicating that the economic growth in the second quarter was not bad. On the cost side, 1) Main operating costs remained flat compared to the first quarter, as the transmission of oil prices has a lag of 1-2 months, so the year-on-year increase in oil prices in the second quarter has not yet been reflected in costs, not to mention the subsequent decline in the third quarter; 2) Selling and administrative expenses saw a decrease in year-on-year growth rate to 5.2% (vs. 5.7% in the first quarter), benefiting from the company's cost control strategy and the slowdown in wage inflation; 3) Decline in interest costs and effective tax rate, the ratio of interest expense to EBIT decreased from 12.6% to 12.3%, and the income tax to pre-tax profit decreased from 12.7% to 10.9%. The increase in revenue and decrease in costs drove the improvement of the non-financial net profit margin from 11.2% in the first quarter to 11.6%.

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ROE continues to rise, with non-financial ROE increasing from 23.3% to 24.3%, mainly boosted by the non-financial net profit margin and asset turnover rate (0.73 vs. 0.72 in the first quarter). The reduction in corporate bond issuance scale in the second quarter affected the leverage level compared to the first quarter, with the corporate bond issuance scale decreasing from $625 billion in the first quarter to $434.6 billion, and the leverage level dropping from 2.89 to 2.86.

Internal Structure: Technology slows down but remains the main support, contributing most to buybacks and capital expenditures; Cycle recovery still awaits catalysts

In the second quarter, the U.S. stock market showed a switch in technology "down" and cycle "up": 1) Slowing down of technology growth. Semiconductor and equipment second-quarter profit growth was 57%, weaker than the 88% in the first quarter; software and services (9% vs. 18% in the first quarter) continued to weaken, media and entertainment have turned negative (-8.1% vs. 38% in the first quarter), only technology hardware rebounded from -2.3% to 3.1%; in contrast, the cycle is starting to recover, with energy profit growth turning positive year-on-year (7.7% vs. -23.4% in the first quarter), financials (18% vs. 10% in the first quarter), utilities (16% vs. 10% in the first quarter), and materials (-9% vs. -20% in the first quarter) showing improved growth; 2) Contribution to profit growth, information technology decreased from 80% in the first quarter to 33%, while communication services contribution turned negative. Cycle contribution increased, with energy contribution changing from a drag in the first quarter to 24%, and financial contribution remaining relatively stable

In addition, although the growth rate is slowing down, technology stocks, especially the 7 leading stocks, remain the main support for cash flow, capital expenditures, and buybacks. Specifically,

► Capital expenditures are mainly driven by technology stocks. In the second quarter, non-financial capital expenditures of the S&P 500 accelerated to expand from $233.6 billion in the first quarter to $243.3 billion. Information technology, discretionary consumption, and communication services increased compared to the first quarter, while essential consumption, industrial, and materials continued to decrease. The capital expenditures of the 7 leading technology stocks grew by 52% year-on-year, contributing 24% to the overall total (compared to 21% in the first quarter). Excluding the capital expenditures of these 7 companies, the overall capital expenditures actually declined.

► Technology stocks are also the main driving force behind buybacks. Operating cash flow in information technology (18% vs. 12% in the first quarter) and communication services (24% vs. 20% in the first quarter) accelerated, but the slowdown in cash flow growth in healthcare, essential consumption, and discretionary consumption dragged down the growth rate of non-financial operating cash flow from 10.8% in the first quarter to 7%. Non-financial buyback volume increased from $201.1 billion in the first quarter to $214.6 billion, with information technology, finance, and discretionary consumption leading the increase in volume while healthcare saw a significant decline. The buyback volume of leading technology stocks doubled year-on-year, surpassing $60 billion, accounting for the overall volume to increase from 26% in the first quarter to 28%.

Sector Focus: Positive Outlook on AI; Pressure on Low-End and High-End Consumer Goods, Resilience in the Mid-End; Real Estate Demand Awaits Recovery; Weakness in Manufacturing

Tech stock earnings are slowing down, but the outlook for AI remains positive. Leading tech stocks contributed to a 11% year-on-year growth in S&P 500 index EPS, with a 6.6% increase, but net profit declined from the high point of 61% in the same quarter last year, further narrowing to 35% in the second quarter, with a relatively stable net profit margin of 23.3% in the second quarter, almost on par with the 23.5% in the first quarter. However, companies remain optimistic about the future of AI: 1) AI technology has begun to help companies convert revenue, with Meta and Google stating that this quarter's advertising revenue has benefited from the improvement in AI technology conversion, and Nvidia also mentioned applications from the automotive and manufacturing sectors as one of the main reasons driving revenue growth this quarter. 2) Leading tech companies will continue to expand their investments. Despite the slowdown in performance growth once again sparking discussions in the market about the turning point in the AI industry trend, Amazon, Apple, Meta, Microsoft, and others have all clearly stated that they will continue to increase their capital expenditure. Amazon and Nvidia CEOs stated that "generative AI is still in a very early stage" and "the momentum of generative AI development is accelerating"; Google CEO stated that "the risk of underinvestment is far greater than the risk of overinvestment".

Consumption overall slows down, with low-income groups being the biggest drag, while high-income groups prefer travel experiences. Affected by the economic downturn, the profit growth rate of the consumption sector has slowed down. Consumer services (13.9% vs. 47.4% in the first quarter) and optional retail (31.6% vs. 48.3% in the first quarter) have seen more significant declines, while essential retail in necessary consumption (7.6% vs. 9.1% in the first quarter), food, beverages, and tobacco (-1% vs. 3.4%), as well as household and personal goods (6% vs. 13% in the first quarter) have shown relative resilience. Specifically,

► Ordinary consumers are starting to pursue value for money. Retailers generally stated in their financial reports that consumers, amidst macroeconomic uncertainties, are beginning to seek maximized value and are more price-sensitive, leading businesses to implement price reduction strategies to attract customers. Major retailers such as Walmart, Target, and Costco all indicated in the second quarter that they have lowered prices or introduced low-priced private label brands to enhance their price competitiveness, with second-quarter profits still maintaining positive growth. Online retailer Amazon also stated, "Consumers are more inclined to buy cheaper goods and focus on purchasing daily necessities." In addition, mid- to high-end apparel and cosmetics companies such as Nike, Lululemon, and Ulta Beauty all reported a slowdown in U.S. sales in the second quarter, as their previous inflation-driven price increase strategies restrained consumer spending.

► Decline in demand for dining out. Whether reflecting low-end consumption like McDonald's or higher-priced Starbucks, profits in the second quarter both contracted by 8%, mainly due to a decrease in consumers' willingness to dine out offline. McDonald's mentioned in its financial report, "The biggest impact comes from a reduction in visits by low-income consumers, so in June, we launched a $5 combo meal to increase the frequency of low-income consumer spending." Starbucks also noted, "The spending patterns of American consumers have changed, with an overall decrease in transaction frequency."

► Automakers implement price reduction strategies, with electric vehicles being a significant drag. Auto manufacturers saw a 17% decline in profits in the second quarter, with losses in the electric vehicle business being the main drag on profits. Traditional fuel car manufacturers General Motors and Ford both stated that they will delay the launch or cancel new electric vehicle models, and expect losses in related businesses to further expand in the second half of the year. General Motors will cut over 1,000 jobs globally to cope with industry downturn pressures Tesla's profitability is constrained by three factors: increased AI investment, decreased car deliveries, and lower average selling prices. The company stated that cost reduction remains a key focus going forward, with a potential global workforce reduction of around 14,000 employees in the second quarter.

► Low-end consumer retailers face dual pressures of declining demand and intense competition. Discount retailer Daler's second-quarter profit growth declined by 20%. The management attributed the weak sales in the second quarter to tight funds of core customers, namely the decrease in purchasing power of low-income groups, as well as the company's lack of burden capacity to deal with retail theft losses from large retailers. On the other hand, while large retailers are implementing price reduction strategies, the company mentioned that its market share may be affected by competition.

► High-income consumers prefer experiential consumption. Consumer stocks reflecting travel demand, such as Hilton, Marriott, and Royal Caribbean, still have support for profitability in the second quarter. Hilton mentioned in its performance report that excess savings of low-income consumers have been largely depleted, but high-income consumers have strong consumption power. Marriott and Royal Caribbean noted that American consumers' spending on leisure travel remains healthy, and consumers' financial conditions are relatively sound.

Real estate new home demand is insufficient, leading to a slowdown in builder profitability. The significant decline in US bond rates in the fourth quarter of last year catalyzed the recovery of property sales in the first quarter of this year, with new home sales reaching 683,000 units, driving a year-on-year profit growth rate of 23% for residential builders in the first quarter. However, the fluctuation in interest rate expectations in the second quarter led to a rise in rates again, resulting in a decline in new home sales and a slowdown in profit growth for residential builders to 5.6%. Horton Homes, Lennar Homes, and Pulte Homes all mentioned that high home prices and high rates are suppressing buyers' affordability. Currently, developers are still offering incentives such as mortgage rate buyouts to help buyers reduce monthly payments. Due to the impact of short-term demand uncertainty, builder delivery volumes did not increase significantly, so the number of new home starts also declined in the second quarter. However, builders remain optimistic about long-term US real estate demand, citing population growth, immigration, and household formation as strong supports.

Manufacturing continues to decline, with profit growth turning negative. Consistent with the trend reflected by the manufacturing PMI, demand in the industrial sector continued to decline, with second-quarter revenue growth slowing to 2.5% (vs. 3.6% in the first quarter), and profit growth turning negative from 5.5% in the first quarter to -2.6%. Major industrial giants in their financial reports all mentioned cost control to address the demand decline in the current economic downturn. Industrial giants such as Caterpillar, 3M, and Honeywell faced some pressure on sales and revenue this quarter, but profit growth was achieved, mainly benefiting from effective cost control supporting profit margins The infrastructure bill still has a certain boosting effect, Caterpillar stated that the U.S. market benefits from government infrastructure projects and home sales, with overall demand remaining strong.

Outlook: Long-term optimism for U.S. stocks, short-term facing fluctuations, "buy back when it drops too much"; gradually shifting towards profit beneficiaries and pro-cyclical sectors after rate cuts

The micro-situation reflected by companies in the second quarter is basically consistent with our outlook for the second half of the year ("Global Market Outlook for the Second Half of 2024: Loose Monetary Policy is Over Halfway"), that is, "soft landing" is still the benchmark, with a misalignment between consumption, real estate, and investment, where future consumption "declines," real estate and investment "rise." Consumption is trending downwards, but even in a pessimistic scenario, it is only a month-on-month 0 growth, consistent with the resilience and preferences of consumers reflected in corporate financial reports; real estate is trending upwards, but limited by the downward space of interest rates and high housing prices, the degree of repair is limited; investment is trending upwards, with AI industry demand supporting local scale growth, capital expenditures of leading technology companies continue to expand, and the corresponding year-on-year growth rate of computer equipment may continue to rise.

The pattern of earnings in the second quarter shows that when technology/consumer and cyclical real estate are "not in sync," it is also a time when growth is declining and monetary policy is loose. The former is not sensitive to interest rates (90% of residential mortgages are fixed-rate mortgages) and relies more on industry trends, while the latter is more sensitive to interest rates, but repair will take time. The recent rate cut expectations have led to a rapid decline in U.S. bond rates, which has locally made financing costs lower than investment returns, such as a 30-year mortgage rate of 6.7% lower than the 6.8% rental return rate, and July real estate data has improved as a result, similar to February. If this trend can continue, it is expected to become the next driver of growth. Furthermore, if a slight easing of monetary policy can be effective, it will also help offset the pressure of declining growth, at least not a deep recession's hard landing. **

In this context, discussing individual data will inevitably lead to different conclusions from different perspectives, and both pessimists and optimists can find reasons. Therefore, it is more important to discuss the "recession" or rate cut trades from the essence of this cycle, which is also the reason why we introduce the credit cycle analysis framework as the basis for judging the Sino-US cycle ("New Changes in the Sino-US Credit Cycle"). Of course, there are still some "left-leaning" views now, but compared to the already fully priced rate cuts and "recession concerns", unless there is sufficient evidence of a deep recession risk, linearly extrapolating in this direction is not meaningful (such as recent U.S. bonds and gold), and instead, assets that may benefit from rate cuts should be considered. This is also the meaning of our suggestion to "think and act in reverse" moderately ("New Thinking on Rate Cut Trades").

In the short term, after the market quickly recovered in August, it is now in a relatively indecisive position, not as extremely pessimistic, but there are not many signs of improvement yet, so fluctuations at this stage are inevitable. Similar to before the rate cut in July 2019. Moreover, there are also many events in the next two weeks, such as the non-farm payroll on September 6, the second round of major election debates on September 10, and the FOMC meeting rate cut on September 19, which could all become "triggers" for market volatility. However, if the trend is clear, volatility actually provides more trading opportunities.

Authors: Liu Gang S0080512030003, Yang Xuanting S0080524070028, Source: [Zhongjin Insight](https://mp.weixin.qq.com/s? __biz=MzI3MDMzMjg0MA==&mid=2247744640&idx=1&sn=56b3df018dd56e7bce8136a1d85ee428&chksm=eb9e7148c317c9db1f2d6b506249d7d2a0df6f42109a02169f77d77af1c743ee62f71e8ec69a&scene=126&sessionid=1725579327), the original title: "中金: Where is the U.S. recession - Microscopic clues from U.S. stock performance"