Earnings Outlook: Show Us The Growth

Transcript

We are coming into earnings season, and I’m paying attention to three things.

1) Company margins

The first is margins.

So, if you look at the U.S. labor market, it’s really, really tight. And my question is, as I look at this very hot labor market, if the squeeze is not coming from the labor market, where is it going to come from? As companies hoard labor because of labor shortage, it’s likely going to hit profitability and margins.

Now, margins in the U.S. have come down a fair bit versus the elevated levels last year, but it’s still above the pre-pandemic levels. So how much more there is for margin to fall is the first area that I am paying attention to.

2) Being selective

The second is selectivity. Which sectors are likely to carry earnings? And this is really in the context of the very meaningful rate repricing that we have seen in recent weeks. It’s even more important to be selective when rates are staying higher for longer. And here there is a beautiful symmetry in what is carrying the U.S. stock market and also what is carrying the U.S. earnings picture. And again, here the mega tech and the AI theme have been proven resilient and likely going to continue to be resilient.

3) Resilient U.S. consumers

And the third area that I am paying attention to is consumers. So the resilient consumers, U.S. consumers have been holding up the economy and also the earnings picture so far this year. But the pandemic buffer is wearing out and running down. Just how much more can we expect consumers to come to the rescue? That’s another, the third, area that I am paying particular attention to.

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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.

Split earnings outlook

Notes: The chart shows 12-month forward aggregate earnings estimates for the S&P 500 and S&P 500 excluding mega cap names (the largest seven mega-cap stocks). The data has been rebased with January 2023 = 100.

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 expectation. 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 assess profit margins, shaped by earnings and revenues, for cracks, too. 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.

High stakes for earnings

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.

Market backdrop

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.

Stubbornly high U.S. CPI inflation data this week could bolster the recent bond yield surge as markets expect the Fed to hike rates this month after a June pause. The Bank of Canada hiked after a pause – and markets are leaning toward odds of another hike this week. We think central banks will be forced to keep policy tight to lean against inflationary pressures.