The Fed is not yet ready to ease its pace of rate rises and expectations for company profits are likely to face headwinds for some time. US equities are still expensive, and could lead global markets lower. Remain patient and underweight global equities.
Punctuated by bear market rallies, the global equity market has fallen 26% from its end 2021 peak. In their fourth rally of 2022, global equities rose 13% in US dollar terms during Q3, only to fall back again. This most recent outburst of positive thinking was premised on the notion that inflation had peaked in July, which would in turn enable the Federal Reserve (Fed) to moderate its pace of interest rate rises. It was not to be: a continued rise in US core CPI to 6.3% for the year to August doused hopes of an inflation peak, while pronouncements from Fed Chair Jerome Powell underscored the Fed’s commitment to fighting inflation and avoiding a premature reduction in interest rates.
Until unemployment rises, US wage inflation is unlikely to fall
Part of the problem is the robust health of the US economy in the face of a 2.25% increase in interest rates since March 2022. Although goods price inflation is moderating as supply chain pressures ease and oil prices settle below US$100 a barrel, wage increases are running at 5-7%. The risk that higher wage expectations become embedded is too high to allow the Fed to change course now. Until unemployment begins to rise, US wage inflation is unlikely to fall back to a more comfortable 3-4%.
This could take some time, because monetary policy works with unpredictable lags. For example, US 10-year mortgage rates have increased from 2.3% to 5.8% in the past year but the US housing market is yet to cool. Business sentiment indices have yet to turn negative and most US companies continue to report growing sales and orders. US consumer confidence may be lower than it was during the Global Financial Crisis (GFC) but, in stark contrast to the aftermath of the GFC, savings accumulated during the pandemic and full employment have so far protected households from inflation.
The economic situation in Europe is of greater immediate concern
The US may continue to defy gravity for the time being but the economic situation in Europe is of greater immediate concern, given the extreme rise in natural gas prices and the probable need for rationing now that Russian gas flows to Europe have been shut off. The fiscal support that UK and European governments have announced to dampen the impact of energy price rises will go some way to mitigate economic damage and reduce headline inflation. The flipside of this intervention is that a more prolonged period of higher interest rates may be needed in order to bring core inflation back to target. Europe faces a tough period ahead and, as it accounts for a fifth of global GDP, its travails will be felt elsewhere, too.
The outlook for Asia is more difficult to judge. The Chinese economy is battling a deflating property market, rolling Covid-19 restrictions and damage to business and consumer confidence from unpredictable government policies. Greater government support for the Chinese economy would be welcomed by equity markets, as would an easing of Covid restrictions and a broader roll-out of vaccinations. The rest of Asia is dependent on export growth and is weighed down by the surge in the US dollar and rising US interest rates.
Bank of America’s global earnings revisions (number of stocks upgraded versus the number of stocks downgraded) began to fall in January 2022, coincident with the peak in MSCI ACWI. Although the indicator has turned negative, the rate of change is only in line with the average since 2010. Expectations for the upcoming Q3 earnings reporting season are falling more rapidly than they did ahead of Q2[1], but the distribution of these earnings downgrades is uneven. While the energy sector enjoys upgrades, earnings expectations for technology, consumer discretionary and industrials companies are falling.
During Q2 earnings reports it was consumer companies such as Walmart and Target that lowered expectations, but this was offset by improving profits at energy companies. Amongst those suffering the most impactful downgrades to Q3 earnings expectations are former market leaders such as the semiconductor sector, along with companies such as Meta, Amazon, Alphabet and Moderna.
Automation and energy efficiency companies are reporting strong order books
The picture is far from uniform, even within industries. Process automation and energy efficiency companies such as Rockwell and Schneider are reporting strong order books, with no indication of cancellations. Meanwhile, warehouse automation company Kion highlighted order cancellations when warning of a substantial profit disappointment. Chemical companies such as Dow and Huntsman are concerned about energy costs, whilst aerospace stocks such as GE and Boeing have said supply chain and labour pressures are taking their toll on deliveries. More worrying are recent disappointing statements from short-cycle companies, such as Swedish ball-bearing manufacturer SKF and Fedex[2], which are the first to feel the pinch in an economic downturn.
The outlook for global earnings expectations is increasingly challenged by slowing economic momentum. Charging higher prices, as companies pass on the impacts of inflation, can provide nominal revenue growth but it can also ultimately destroy demand. Meanwhile, even if price inflation moderates in 2023, companies’ margins could be squeezed by rising labour costs (which tend to lag inflation) and a reluctance to reduce headcount, for fear of not being able attract staff when the recovery arrives.
The majority of large multi-national corporations have so far been able to pass on higher costs, but this may not prove easy when demand cools. The CFO of a Connecticut industrial company I met with recently explained how travel restrictions, supply chains, frictional trade costs, climate impacts and energy security all increase the complexity of managing a global business. For many companies it is increasingly difficult to juggle forecasting demand, finding skilled labour and managing inventories.
Market expectations for earnings growth in Europe and China are lower than for the US, and their valuations have decoupled, possibly because investors believe the S&P 500 is higher growth and more defensive than the rest of the world. MSCI China has seen earnings disappoint in each of the past four quarters and Chinese 2022 earnings have been revised down 20% since the beginning of the year. European earnings have been more resilient than in China, but the forward European PE multiple has fallen to 11.5x in anticipation of disappointing profits. By contrast, the risk-reward profile of US equities at the beginning of this earnings contraction is relatively poor: on most valuation measures the US is in the top quintile of expensiveness versus its long-term history.
Europe and China, the nexus of investors’ fears, could be close to a nadir
There is a strong argument for remaining cautious at this point in the cycle. That said, there are reasons for optimism. First, supply chains are beginning to improve, most company balance sheets are strong and consumers have jobs and savings. Secondly, although inflation will prove sticky on the way down, we may be close to the peak. Thirdly, a lot of bad news has already been discounted by the markets: sentiment is extremely poor, investors are conservatively positioned and market volumes are low.
Europe and China, the nexus of investors’ fears, could be close to a nadir. Now that the Nordstream 1 gas pipeline has been turned off, Putin is no longer able to use this as a threat. European governments are acting to support citizens and improve energy security. In China there is scope for more determined support for the economy and an adjustment to Covid policies following this month’s National Congress of the Chinese Communist Party.
Even amidst macro-economic uncertainty there are good companies that are solving the problems of people and the planet, and are worthy of investment. For thematic investors, the current opportunities for stock selection are plentiful. Our recent meetings with medical technology companies suggest that hospital staff shortages are easing and this should allow a recovery in discretionary procedures that will benefit companies such as Smith & Nephew.
The strong order books at process automation companies such as Rockwell and Schneider highlight the importance of investing to cope with the shortage of skilled labour. Meanwhile, the energy shock precipitated by the invasion of Ukraine and low investment in the oil and gas industry have thrown a spotlight on the need to invest in energy efficiency and security, providing a long-term tailwind for companies such as Flowserve, Ingersoll Rand and Air Liquide.
A further rise in real yields and a decline in earnings could take the S&P 500 into the 3,000-3,400 range
We are seeing opportunities, but equities overall remain relatively expensive given the contraction in the equity risk premium we have experienced as bond yields have risen. A further rise in real yields combined with a decline in earnings could take the S&P 500 Index into the 3,000-3,400 range (down 15% to 20% from the current level). At their lower valuations European and Asian stock might be insulated, but they would not be immune.
When it comes, market capitulation can be swift, but a curious feature of bear markets is that many investors are unaware of having reached the bottom. Ascertaining when we have reached the trough may be more art than science, raising the question: How can investors tell when a bear market has run its course and a new market cycle is beginning?
[1] Source: Credit Suisse
[2] Fedex missed its Q1 earnings expectations by 33%, gave quarterly guidance 50% below consensus and withdrew its FY2023 guidance entirely.
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