by Kevin McCreadie, CFAÂź, MBA, AGF Management Ltd.
Following a stellar first quarter earnings season, investors must contend with a growing list of headwinds that threaten to upend equity markets. AGFâs CEO and Chief Investment Officer explains why focusing on companies with âcleanâ balance sheets and manageable debt loads can be a good way to navigate what lies ahead.
First-quarter earnings season is winding down in the United States and across most other global markets. Whatâs your take on it to date?
The numbers have been exceptional and much better than most market participants expected as economies around the world begin to recover. At last count, the percentage of âbeatsâ for S&P 500 Index companies in the U.S. was close to 90%, according to Bloomberg. And for S&P/TSX Composite Index companies in Canada, itâs more than 50%. But maybe more impressive than that is the amount by which some company earnings have beaten expectations. In many cases, including several from the vaunted tech sector, both the top line and the bottom line were at least 40% higher â if not more âthan the average forecast going in. In turn, weâve seen upward earnings revisions across the board, which has brought multiples down and slowly pushed equity markets higher. So, earnings season has been generally positive for investors and has shown that the re-opening of economies around the world is well underway. That said, there has also been something sobering about how stocks have performed over the past few weeks. On average, they havenât moved nearly as much as one might normally expect when earnings are this good and while broad indexes like the S&P 500 continue to grind out new highs, recent moves have been full of fits and starts and weâve experienced almost as many down days as up since about the middle of April.
What accounts for that volatility?
It may reflect a crossroad that investors have now reached. After being focused on the reopening for the past several months âand largely pricing it in â they are now turning their attention to the future and what a post-pandemic economy could mean for markets. As such, at least some of the volatility can be attributed to the cautious guidance that has accompanied earnings reports so far. While the first quarter results were outstanding, many companies have warned about headwinds going forward and this is making investors think a little harder on some the concerns that have been swirling in the marketâs consciousness for months, and which weâve been warning about for a while now. This includes things like supply shortages which are driving up costs for companies and putting more pressure on future margins, but also reflects a growing concern that labor costs in certain sectors will continue to rise as more areas of the economy re-open and companies look to re-hire their workforces simultaneously with others. Of course, one of the solutions to this is passing those costs on to consumers, but that has its own drawbacks including the potential for higher inflation. Remember, thatâs already a growing risk given the amount of fiscal stimulus now in play. What used to be described as a punch bowl of accommodation is now a trough, and the threat of an overheated economy leading to price increases and higher interest rates to curb them is only going to become more persistent as time passes. This scenario is clearly a worry and would be particularly hard on growth stocks whose earnings are generally more sensitive to rate hikes. In fact, just a few days ago, markets got spooked when Janet Yellen, the U.S. Treasury Secretary and former Chair of the U.S. Federal Reserve hinted â out of line, some think â that interest rates may need to rise to ensure the U.S. economy doesnât overheat. Sheâs since walked back those comments, but the risk of it hasnât gone away.
How nervous should investors be?
I wouldnât be surprised if there was a pullback of 5% or more sometime soon, but thatâs not a reason to run for the hills. Instead, now may be the time for investors to up their game and reconsider the benefits of owning companies with the strongest fundamentals. While the idea that quality matters may not be obvious to everyone jumping into the market these days, itâs reasonable to believe that businesses with âcleanâ balance sheets and manageable debt loads are in much better position to manage through margin pressures that may result from higher costs and potentially higher interest rates than other businesses who do not. By extension, itâs equally reasonable to assume that those who take greater account of these strengths should be rewarded more than others who just continue to focus on the binary themes of stay-at-home stocks versus return-to-work ones or Growth versus Value, which have dominated over the past year. Thatâs not a guarantee of better returns over the short term, but quality usually ends up being a good catalyst of performance over the long run.
Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Limited. He is a regular contributor to AGF Perspectives.
