Underneath the surface, earnings reports revealed a tremendous number of clues about the rapidly changing economic landscape. Who are the winners and losers and what does it mean for stocks?
About 80% of US companies exceeded street earnings-per-share forecasts by an average of 4%. However, investors were often disappointed by companies leaving their guidance for the year unchanged due to high uncertainty.
Multiple hurdles ahead
Companies noted strong underlying consumer demand, but firms expressed caution as to how long the consumer can remain healthy while facing fading fiscal support and rising prices that are eroding spending power.
Inflation: Rising costs are impacting corporate margins, already under pressure from the supply-chain crisis. The war in Ukraine is only adding more stress to supply chains, causing prices to spiral higher, particularly for food and energy, which is particularly visible to the average consumer. However, there are reasons to be optimistic, with signs of inflation peaking and potentially rolling over – albeit very gradually.
China: Lockdowns in response to rising Covid cases have put enormous pressure on trade, adding to supply-chain bottlenecks and leading many companies to lower their guidance. Growth will also likely be affected by China’s “Zero-Covid” policy. Signs of a shift away from this policy to more of a Western approach would be very well received by markets, but they appear unlikely for now. So far, China has doubled down on its policy of lockdowns, thus the risks remain elevated and a wild card that is hard for economists to forecast – both in terms of growth and inflation. On a positive note, cases are dropping. Moreover, local officials are reacting to the fact that unemployment is rising fast, and thus may be in favor of taking measures to shore up the economy.
A strong dollar: The US Dollar Index has exploded higher to a level not seen since January 2002, introducing significant FX headwinds for US companies and stress for emerging markets. This has led many companies to lower their guidance as revenue in foreign currency becomes less valuable in dollar terms. Similarly, tightening financial conditions from higher yields should put pressure on the most sensitive parts of the economy.
Investors are looking past the strong growth seen in 2021, as the outlook is now blurred by several simultaneous headwinds: Central bank hawkishness and reduced fiscal support; lockdowns in China; the war in Ukraine; ongoing supply chain disruptions.
As such, last year’s pandemic winners have been the losers of this earnings season. Stay-at-home stocks from Amazon and Netflix to Teladoc, Peloton, Shopify, and Zoom have all corrected sharply. The new reality is that the high growth rates seen during 2020 and 2021 are likely behind us. Not only are customers purchasing less online as the economy reopens, but corporate America is facing pressure on margins as costs increase and competition intensifies.
Nonetheless, there are reasons not to become overly pessimistic. Quality names with market-leading positions, strong business moats, accompanied by high profitability, and robust balance sheets should be able to navigate the market cycle better than smaller peers. For example, we have seen that Apple and Microsoft have done well despite the stress in the tech space. Leaders in defensive sectors have also held up well. For example, consumer staples have held up well as they are quickly pushing through price increases.
In the meantime
Oil & Gas comes out as a major winner from the earnings season. Integrated oil & gas, despite facing costs because of the war in Ukraine, profit margins have ballooned because of higher energy prices.
Companies have said they are reluctant to increase production and invest in medium-term projects as they believe energy prices could face downward pressure in the next couple of months. Thus, additional energy supply could remain limited as firms are unwilling to bear the risk of increasing production. In this environment, thus the energy sector remains a pocket of relative winners which tend to benefit from a positive market backdrop.
Travel and leisure, or the “reopening” names are major beneficiaries of the post-pandemic era as consumers prioritise spending on experiences rather than online purchases. Airlines, hotels, and online travel firms all delivered strong numbers, lifted by price increases. The challenge with the re-opening theme, however, is that consumer spending power may be eroding because of inflation and the end of fiscal stimulus. There are, for instance, signs that consumer debt is rising fast. As a result, selectivity remains key. We look to high-quality market leaders that provide essential goods and services, that are also capable of thriving in a more difficult, lower-growth environment. A barbell approach with both growth and value names may be ideal to navigate the market volatility.
The economic outlook has clearly weakened, and uncertainty has risen, but the key question is whether the headwinds will prove relatively temporary or whether they will endure. Name selection is key to navigating the current market environment and those higher-quality names ‘winners’ in Q1 earnings could provide some ‘anchor’ to portfolios. However, risks of the outlook worsening cannot be ruled out until the Fed signals it is ready to consider taking its foot off the pedal.