Earnings Outlook: Show Us the Growth
- Higher expected corporate earnings mask broad pressure under the surface. We see more earnings pain ahead and look for opportunities at the sector level.
- U.S. Treasury yields surged and stocks dipped last week. Data confirmed the U.S. labor market is still tight. We see signs markets are adjusting to the new regime.
- All eyes are on U.S. CPI inflation data out this week. Continued evidence of stubbornly high inflation could add momentum to the recent rise in bond yields.
Bond yields have jumped, and we think markets are at a key juncture as central banks are poised to hold tight on policy. As Q2 results begin, corporate earnings need to deliver on market expectations to support stocks, in our view. We see a key divergence in earnings forecasts: They have risen for a few tech firms, while the rest stagnate. Profit margins are shrinking, and we see more pressure ahead. So we get granular and favor sectors like healthcare within developed market stocks.
Q1 earnings growth was flat to slightly negative, Refinitiv and Factset data show. That masks significant divergence: We see a common denominator between what’s driving market performance this year and earnings – the artificial intelligence (AI) buzz. S&P 500 earnings forecasts for the next 12 months have risen in recent months (dark orange line in the chart) along with the market rally driven by tech firms with the largest market capitalization. Stripping out those mega-cap tech stocks, forecasts are flat this year (yellow line). 2023 consensus estimates have been cut but remain well above our expectations. We expect Q2 data will be similar to Q1 as the reporting season kicks off this week, with a contraction hitting in the second half of 2023. We also assess profit margins, shaped by earnings and revenues, for cracks. Margins jumped during the pandemic when consumer demand for goods was strong and companies could push up prices as input costs soared.
Margins have slid since last year as spending shifted back to services, but they remain above their pre-Covid highs. At the same time, data like Friday’s U.S. jobs report reinforce how tight labor markets are in the U.S. and Europe. The key question right now, in our view: If rate hikes are not squeezing the labor market, where will the squeeze come from? Corporate profit margins, we believe, as wage gains and still-solid employment take a bigger toll on margins than in the past. Tight labor markets have caused employers to up wages to attract new hires. Broad worker shortages could incentivize companies to hold onto workers – even if sales decline – out of fear they won’t be able to hire them back. This outlook poses the unusual possibility of “full employment recessions” in the U.S. and Europe.
Last week’s surge in government bond yields put some pressure on equities – and highlights that companies will need to deliver on the market’s earnings expectations as the Q2 reporting season gets underway to avoid more pressure. Resilient consumers have helped support earnings, but we see them exhausting the savings built up during the pandemic this year.
Yet not all corporate sectors will suffer margin pressures in the same way, as is reflected in market pricing. We tilt toward certain sectors within a modest underweight to developed market equities on a six- to 12-month tactical horizon: divergences create opportunities depending on what’s priced in. For example, technology and healthcare margins saw a boost during the pandemic. They could avoid the broad decline we expect as quality sectors that stand to benefit from mega forces, like AI and aging populations. These forces are driving profits now and, in the future, – and markets are reacting, as with this year’s tech rally. Plus, we like healthcare’s more attractive valuations and generally steady cash flow during economic downturns.
We also like the industrial sector, particularly automakers as they better price in future earnings risk while adding diversification and quality to our defensive portfolios. Automakers would also benefit if the downturns we expect do not occur and consumers stay strong. With a regional lens, we see the earnings improvement at European financials carrying on: Higher interest rates should boost their profit margins, and some are returning capital to investors via buybacks.
Bottom line: We see tight labor markets squeezing profit margins, and we think earnings will come under more pressure in the second half of the year. We think this macro environment is not a friendly one for broad asset class exposures. That’s why we get granular within developed market stocks and identify our selective preferences across regions and sectors.
U.S. 10-year Treasury yields approached 15-year highs above 4% and stocks dipped last week after U.S. jobs data showed a still tight labor market. The unemployment rate fell lower, labor participation hasn’t risen further and wages are still growing even after the Fed’s rapid rate hikes. We think the yield move and equity retreat signal we are at an important juncture: Markets are coming around to our view that central banks will be forced to keep policy tight to curb inflationary pressures.
Last week’s U.S. jobs data reinforced that labor supply remains constrained. Looking beyond the increase in overall payroll employment shows the extent of the labor shortages. The labor participation rate – the share of the population in work or looking for jobs – hasn’t increased in the last four months. See the chart. And the unemployment rate remains near a five-decade low. That means the share of the population in employment hasn’t grown much this year.
Data on job vacancies corroborate this picture. The number of job vacancies only fell slightly. The key message? Companies are not as effectively finding available workers since the pandemic struck three years ago.
That’s helping sustain wage pressures. Average hourly earnings growth stayed high in June and is running at a pace well above what the Fed thinks is required to hit its 2% inflation target. We think these inflationary pressures compel the Fed and other central banks to keep policy restrictive: and so they’re holding tight – the first theme of our midyear outlook.
1 Holding tight
- Markets have come around to the view that central banks will not quickly ease policy in a world shaped by supply constraints – notably worker shortages in the U.S.
- We see central banks being forced to keep policy tight to lean against inflationary pressures. This is not a friendly
- The backdrop for broad asset class returns, marking a break from the four decades of steady growth and inflation known as the Great Moderation.
- Economic relationships investors have relied upon could break down in the new regime. The shrinking supply of workers in several major economies due to aging means a low unemployment rate is no longer a sign of the cyclical health of the economy. Broad worker shortages could create incentives for companies to hold onto workers, even if sales decline, for fear of not being able to hire them back. This poses the unusual possibility of “full employment recessions” in the U.S. and Europe. That could take a bigger toll on corporate profit margins than in the past as companies maintain employment, creating a tough outlook for DM equities.
- Investment implication: Income is back. That motivates our overweight to short-dated U.S. Treasuries.
2 Pivoting to new opportunities
- Greater volatility has brought more divergent security performance relative to the broader market. Benefiting from this requires getting more granular and eyeing opportunities on horizons shorter than our tactical ones. We go granular by tilting portfolios to areas where we think our macro view is priced.
- We think dispersion within and across asset classes – or the extent to which prices deviate from an index – will be higher in the new regime amid the various crosscurrents at play, allowing for granularity. That offers more ways to build portfolio “breadth” via uncorrelated exposures, in our view.
- We think it also means security selection, expertise, and skill are even more important to achieving above-benchmark returns. Relative value opportunities from potential market mispricing are also likely to be more abundant.
- Investment implication: We like quality in both equities and fixed income.
3 Harnessing mega forces
- Mega forces are structural changes we think are poised to create big shifts in profitability across economies and sectors. These mega forces are digital disruption like artificial intelligence (AI), the rewiring of globalization driven by geopolitics, the transition to a low-carbon economy, aging populations, and a fast-evolving financial system.
- The mega forces are not in the far future – but are playing out today. The key is to identify the catalysts that can supercharge them and the likely beneficiaries – and whether all of this is priced in today. We think granularity is key to finding the sectors and companies set to benefit from mega forces.
- We think markets are still assessing the potential effects as AI applications could disrupt entire industries.
- Geopolitical fragmentation, like the strategic competition between the U.S. and China, is set to rewire global supply chains, we think.
- The low-carbon transition caused economies to decarbonize at varying speeds due to policy, tech innovation, and shifting consumer and investor preferences. Markets have historically been slow to fully price in such shifts.
- We see profound changes in the financial system. Higher rates are accelerating changes in the role of banks and credit providers, shaping the future of finance.
- Investment implication: We are overweight AI as a multi-country, multi-sector investment cycle unfolds.
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