Earnings and Market Performance Trends
According to both Refinitiv and Factset, the growth of Q1 earnings was at a standstill or marginally negative, a facade that conceals a profound disparity. The market dynamics and earnings this year seem to share a common influence – the escalating chatter around artificial intelligence (AI). Mirroring the market rally led by colossal tech firms, projections for the S&P 500 earnings over the subsequent year (depicted by the dusky orange line in the graph) have ascended in recent times. Excluding these mammoth tech stocks, however, the forecasts for this year are stagnant (shown by the yellow line).
Projections for the Year Ahead
Estimates for 2023, albeit reduced, persist significantly above our predictions. We anticipate Q2 data to echo Q1 as the reporting season commences this week, with a downfall anticipated in the latter part of 2023. We also scrutinise profit margins, fashioned by earnings and revenues, for possible fractures. These margins skyrocketed amidst the pandemic when robust consumer demand and companies’ ability to inflate prices due to ballooning input costs prevailed.
Shift in Spending and Labour Market Outlook
Although spending has transitioned back to services causing a decline in margins since last year, they endure above their pre-pandemic zeniths. Concurrently, data such as Friday’s U.S. employment report underscore the strain on labour markets in the U.S. and Europe. A critical inquiry currently circulating in our minds pertains to the source of the squeeze if it’s not rate hikes pressuring the labour market. We propose it will emerge from corporate profit margins due to rising wages and stable employment impacting margins more substantially than previously.
Prospects of Full Employment Recessions
Rigorous labour markets have compelled employers to elevate wages to allure prospective employees. Widespread worker scarcities could encourage firms to retain employees, even if sales plummet, from the apprehension of being unable to re-employ them. This perspective introduces the peculiar concept of “full employment recessions” in the U.S. and Europe.
Pressure on Equities and Consumer Behaviour
The previous week’s surge in government bond yields slightly stressed equities, illuminating the necessity for companies to fulfil the market’s earnings expectations as the Q2 reporting period commences, to evade further strain. Robust consumers have provided a prop to earnings, but we foresee them depleting the reserves accumulated during the pandemic this year.
Sector Performance and Market Opportunities
Nonetheless, not all corporate sectors will endure the same margin pressures, as reflected in market pricing. We lean towards specific sectors within a mild underweight to developed market equities on a six- to 12-month tactical horizon: discrepancies breed opportunities contingent on what’s priced in. For instance, sectors like technology and healthcare witnessed a margin boost during the pandemic. As sectors of quality, they could circumvent the widespread decline we anticipate, thanks to powerful driving forces like AI and ageing populations that are bolstering profits presently and in the forthcoming times.
Preference for Industrials and the European Financial Landscape
We’re also partial towards the industrial sector, primarily automakers, as they aptly factor in future earnings risk while offering diversification and quality to our defensive portfolios. In case the downturns we anticipate do not materialise and consumers remain resilient, automakers would also gain an advantage. From a regional perspective, we anticipate the earnings enhancement at European financials to continue: Higher interest rates should uplift their profit margins, and some are returning capital to investors via buybacks.
A Brief Summary
In a nutshell, we foresee stringent labour markets compressing profit margins and envisage greater pressure on earnings in the latter half of the year. We don’t believe this macro environment is hospitable for broad asset class exposures. Thus, we delve into specifics within developed market stocks and identify our selective preferences across regions and sectors.
Market Backdrop and Policy Decisions
The backdrop of the market displays U.S. 10-year Treasury yields nearing 15-year peaks above 4%, and stocks receding last week following U.S. jobs data that signalled a persistently stringent labour market. The drop in the unemployment rate, lack of further increase in labour participation and continued wage growth even after the Fed’s swift rate hikes underscore this. We believe the movement of yield and equity retreat signal a crucial crossroad: Markets seem to align with our view that to quell inflationary pressures, central banks will need to maintain stringent policies.
The Road Ahead: Inflation and Policy Outlook
Persistent U.S. CPI inflation data this week could amplify the recent bond yield surge as markets expect the Fed to raise rates this month following a pause in June. After taking a break, the Bank of Canada has raised rates – and the markets are veering towards the odds of another hike this week. We believe central banks will be obligated to maintain stringent policies to counter inflationary pressures.