Three Takeaways From U.S. Earnings
- U.S. corporate earnings have stagnated for a year, but Q2 beat a low bar. Expectations of improving margins look rosy. We stay selective in equities.
- U.S. stocks moved sideways, and 10-year Treasury yields surged in volatile trading last week after CPI data. We see inflation on a rollercoaster ahead.
- We’re watching inflation in Japan this week after the central bank loosened its yield cap last month. We see that pulling local and global bonds yields higher.
U.S. corporate earnings have stagnated over the past year even as Q2 earnings improved a bit on better profit margins. We still see a margin squeeze ahead as worker shortages push wages back up, even if that takes longer to play out – our first takeaway. So, the consensus for margins to expand into next year looks rosy, to us. Second, we see clear sector winners and stay selective with and within sectors that delivered earnings growth. Third, we see key regional divergences.
U.S. earnings have stagnated over the past year as pandemic-driven spending shifts normalized, squeezing profit margins. Margins ticked up in Q2, so earnings topped low expectations, partly from companies benefiting from lower input costs. We don’t think this will last. The consensus for profit margins looks too rosy – our first takeaway from Q2 earnings (green line in chart). Firms may struggle to pass on persistent labor costs to consumers: The share of businesses reporting higher prices for their products is the lowest since January 2021 (dark orange line), NFIB data show. We see companies facing higher labor costs from lifting wages to attracting fewer available workers: The workforce is 4 million smaller than it would have been if it had kept growing at its pre-Covid pace, we find. The recovery of jobs lost in the pandemic has masked what has proved tepid job growth. Competition for workers should boost employee wages – at the expense of profit margins and shareholders.
We believe this structural labor shock is poised to take over as the driver of inflation as the pandemic-driven spending mismatch unwinds. That historic shift in consumer spending during the pandemic to goods from services created mismatches in production and consumption, and within the labor market as a result. It drove up prices and led to fatter profit margins, especially in the goods sector. Recent data showing a further sharp drop in goods prices in the July U.S. CPI and cooling Q2 wage data confirmed spending is normalizing. And that means profit margins are starting to normalize as well, even with the slight improvement in Q2. As worker shortages due to an aging population become more binding, we see firms needing to devote revenue to hiring or retaining workers – to the detriment of margins. We see inflation on a rollercoaster as the labor shock takes over from the spending mismatch. If companies try to protect margins from these wage pressures in a stagnant economy, that could add to inflation pressures and result in even higher central bank policy rates. We have evolved our macro framework to account for these forces.
Our second takeaway from Q2 earnings season: Tech met a high bar and selectivity is coming through in earnings. Other sectors that perform well as economic activity picks up fared better than expected, like industrials, communication services and consumer discretionary. As U.S. growth stagnates, it would be logical to question consumer sector resilience – especially as pandemic savings dwindle. But that’s the old playbook: The sector impact may be different. We think workers gaining income share from firms and unemployment staying low could reinforce consumer spending power for some time. We use our new playbook instead to get granular with and within equity sectors. Tech aligns with our preference for sectors delivering earnings growth. But we stay selective in tech with our overweight to the developed market (DM) artificial intelligence mega force theme, tapping into this structural shift within DM stocks, even when the macro is unfriendly to broad equity exposures.