by Joseph V. Amato, President and Chief Investment Officer—Equities, Neuberger Berman
Last week saw second-quarter earnings season get underway and yet another punishing U.S. inflation report.
Many investors think both of these things are nearing an inflection point. Twin peaks are anticipated—with hope in the case of inflation and trepidation in the case of earnings.
We’ll come back to inflation at the end. For the most part, we’ll focus here on the forthcoming earnings season. We think it will prove more important than most, with the real impact coming not from the realized numbers, but from the forward-looking company guidance.
The macroeconomic background is as challenging as we’ve seen in many years, to put it mildly.
U.S. inflation at 9.1%, talk of one-percentage-point rate hikes, COVID-19 lockdowns in China, a growing energy and geopolitical crisis in Europe, falling Purchasing Managers’ Indices, souring consumer confidence and an uptick in U.S. initial jobless claims have raised the likelihood of recession. On the other hand, some current economic data is not that bad; for example, jobs are still being created faster than expected and faster than employers can fill them. This could suggest meaningful capacity to absorb tighter financial conditions without a major slowdown.
Expect a similarly mixed story from this quarter’s corporate earnings reports.
In the run-up, analysts’ estimates have been revised lower for every sector except energy—but that is not unusual, and in fact this quarter’s declines were modest relative to past trends. Analysts’ consensus forecast for year-over-year earnings growth is still positive, at almost 5%. Strip out big tech companies and that estimate jumps to 9%. Remove financials and the consensus is for 12% growth.
That sounds pretty good. Moreover, companies tend to exceed analysts’ estimates, so second-quarter growth of 6% or more should not come as a surprise.
This backward-looking data is unlikely to move the market, however.
We have already seen negative pre-announcements, such as the recent high-profile example from Target, reverberate widely. Pre-announcements are characteristic of a fast-changing environment and are usually about managing down expectations, so they can significantly darken sentiment about what lies ahead.
Now that formal reporting is underway, listen for the tone and commentary from management teams, and brace for similarly bearish, noncommittal or notably conservative perspectives. Look out for clues into consumer sentiment and inflation-resilience from the reports of big consumer companies such as Walmart and Starbucks.
Investors are especially sensitive to these signals now because many believe that earnings will decline over the coming months due to the economic slowdown, but few agree on how far earnings will decline and how much is already priced in. There is an ongoing debate, including on these pages, between those who think the sell-off so far reflects mainly a rise in rates (which lowers price-to-earnings multiples), and those who assume it has anticipated at least some fundamental deterioration in earnings.
We believe it’s a combination of both, but over the next few weeks, management commentary and the market’s response to it should go some way toward more clearly answering these questions.
We believe this is a recipe for more volatility as the unfolding earnings, inflation and rates story plays out further.
We see a powerful feedback loop here: Slowing inflation could signal tighter conditions eating into growth and earnings; slowing growth and earnings could signal relief from inflation and a pause in rate hikes. On balance, given the current stagflationary gloom in markets, we think the first signs of peak inflation, perhaps in the second half of this year, could unleash a relief rally—despite what it suggests about the economic slowdown.
All things considered, however, we remain cautious and continue to favor low-beta equity exposures, with a view to adjusting positions on any extreme market moves, in either direction—whether due to trepidation over peak earnings or relief over peak inflation. With earnings at a crossroads, this reporting season will likely tell us a lot. But, as we have been saying for some time, for real clarity and a bottoming out in equities, we will need to wait for stabilization in inflation and interest rates.
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