U.S. Stocks: Selective As Earnings Stall

Transcript

U.S. corporate earnings have plateaued alongside the stealth stagnation we see in the economy.

Markets see modest earnings growth in Q3 reporting underway, after earnings were flat for a year. That doesn’t reflect the market narrative of a resilient economy, in our view.

Markets see renewed earnings growth over the next year. We see earnings flatlining through year-end.

Here’s why:

1) Unpacking market expectations

Focusing on earnings beating expectations misses the point, to us. We think it’s more about low expectations being met.

Around half of the 10% earnings growth the consensus expects over the next year is coming from just a handful of mega cap stocks. Stripping those out, expectations are more muted – even if too optimistic, in our view.

2) Tough macroeconomic backdrop

Stagnation isn’t a friendly macro backdrop for U.S. equities, in our view.

We see monetary policy staying tight as a shrinking workforce keeps the labor market tight, risking resurgent inflation. If job growth keeps up its current pace, we think wage pressure could weigh on margins, too.

We stay selective in U.S. stocks – and remain underweight on a six- to 12-month tactical horizon.

We favor sectors where earnings are growing, like tech, and harness the artificial intelligence mega force where we see more potential for earnings growth.

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Markets expect a pick-up in corporate earnings to start in the Q3 reporting season that gets underway in earnest this week. We are cautious. U.S. corporate profits have plateaued along with the economy. We think this has gone under the radar. The macro backdrop is bad news for broad equities, we think, but opportunities in stocks abound. We tap mega forces like artificial intelligence (we are closely watching the results of top players) and find value in sectors such as healthcare.

Earnings plateau

Notes: The chart shows 12-month trailing earnings (solid line) rebased to 100 at the start of 2019. The dotted lines are based on 12-month forward aggregate analyst earnings growth estimates. S&P ex-mega cap excludes Alphabet (GOOG, GOOGL), Amazon (AMZN), Apple (AAPL), Meta (META), Microsoft (MSFT), Netflix (NFLX), NVIDIA (NVDA) and Tesla (TSLA).

U.S. earnings growth has sputtered in the past year. See the solid lines in the chart. Markets expect year-over-year earnings growth to turn slightly positive in Q3. We think hopes of a long-awaited pickup are masking a still relatively stagnant growth trend. Modest earnings growth doesn’t reflect the market narrative of a resilient economy either, in our view. Focusing on earnings beating expectations may miss the point, too: that would be confirmation that low expectations are being met. The consensus eyes renewed S&P 500 earnings growth of about 10% over the next year. We’re more cautious – and selective. About half of expected earnings growth is tied to mega caps (orange dotted line), according to LSEG data, where the artificial intelligence (AI) mega force is well-represented. Backing those out (yellow dotted line), expectations for broad equities are muted and overly optimistic, in our view.

We think the current macro backdrop isn’t friendly for broad equity exposures. Higher rates and stagnant growth have weighed on markets, but the move lower in stocks shows they are adjusting to the new macro regime. Stealth stagnation over the past 18 months – taking the average of GDP and gross domestic income, which adds up incomes and profits of households and firms – has been the weakest stretch ever seen outside a recession. We think this has gone under the radar because consumer spending, job growth and GDP have held up. We see stagnation persisting as the Federal Reserve keeps policy rates high in its battle with inflation.

Profit margin pressure

We think the inflation rollercoaster we see ahead creates risks to corporate profit margins. Inflation is cooling now as the pandemic-driven mismatches in spending between goods and services normalize. That could also drag on corporate revenues as pricing power for some firms fades. A shrinking workforce means the rate of growth the economy will be able to sustain without stoking inflation is likely to be lower than we were used to in the past. We see the labor market remaining tight. If job growth keeps up at its current pace, we think wage pressure could come back to bite margins, too. The risk of resurgent inflationary pressures is why we see the Fed holding policy tight. We expect higher rates to increase the interest expense for companies. We think markets are underappreciating profit margin pressure – even if that takes some time. Tech has supported broader margins this year – and cash held by firms has dulled the blow from higher interest expenses.

U.S. stock valuations – the driver of performance this year as earnings stagnated – remain elevated, in our view. Taking into account higher yields, the income in bonds is also more attractive than stocks on a relative risk basis. We stay underweight on broad equities on a six- to 12-month tactical horizon. We favor sectors like tech and harness the AI mega force where we see more potential for earnings growth and expanding profit margins. Tech earnings have come through and are driving the upward revisions in overall profit expectations. We’re closely monitoring the slew of big tech firm earnings reports in coming days. We also focus on granular sector or geographical opportunities, such as healthcare and Japanese equities.

Bottom line

U.S. corporate earnings have stagnated along with the economy. Markets expect a pickup starting with Q3 reporting underway. We are cautious. Broad equities have started to adjust to the new regime of greater volatility, but don’t fully reflect the macro damage we expect. We stay selective and harness mega forces.

Market backdrop

The 10-year U.S. Treasury yield hit 16-year highs near 5.0%, while U.S. stocks fell more than 2%. Markets are coming around to our view of interest rates staying higher for longer in the new regime. Fed Chair Jerome Powell reinforced this in a speech last week – and suggested further hikes could be needed if sustained economic growth drives more persistent inflation. We think the tight labor market constrained by an aging population will eventually feed into inflation pressures.

U.S. inflation takes center stage this week with the Fed’s preferred inflation measure, the PCE. We keep track of how consumer spending is shifting back to services from goods, driving down goods prices and inflation in the near term. Yet, we expect an aging population to keep the labor market tight, putting inflation pressures on a rollercoaster ride.