Fed steals spotlight from earnings
First quarter earnings season is in full swing and based on how the market is performing, one might assume that the results have been disappointing. After all, the S&P 500 is down nearly 6% since the end of March. Still, from our perch, results have been fairly good, despite a handful of high-profile earnings disappointments. And management teams’ forward guidance has also been encouraging. But instead of focusing on the generally good earnings results, the recent down leg in stocks seems to reflect market expectations that the Fed will raise rates even more than expected.
Earnings results have been good
First, a quick review of earnings season so far. About 25% of the market cap of the S&P 500 has reported results. Nearly 70% of companies are beating sales estimates and 80% are beating earnings estimates. In aggregate, earnings are beating by 6%. Incorporating the pace of earnings beats, we expect corporate profit growth of nearly 10% on 11% sales growth for the quarter.
Cost pressures have been top of mind, but consistent with recent quarters, corporate America has been successful at passing on higher expenses to their customers. The strong demand environment makes this easier. As a result, profit margins are holding up and beating expectations. Supply chains are still a challenge and the recent COVID-19 wave in China could be an incremental headwind, but supply chains do seem to be getting a bit better.
Perhaps most encouraging, bottom-up estimates for the full-year and second-quarter have remained flat during reporting season. In other words, companies are generally maintaining their forward guidance. That being said, some companies that benefited from COVID-driven spending trends are experiencing a bit of a "hangover." Offsetting this weakness, reopening beneficiaries, especially travel-related businesses, are seeing surging demand. Overall, we expect S&P 500 earnings growth of 10% this year and 6.5% next year.
Fed to move “expeditiouslyâ€
So, what explains the recent equity market weakness? We think concerns about Fed and other central bank rate hikes are the primary driver. This past week, a slew of Fed officials reiterated their desire to raise rates "expeditiously." Comments from Fed Chair Jay Powell cemented market expectations that the central bank will raise rates 0.5% at their meeting on 4 May. Powell also suggested that “front-end loading†of rate increases would be appropriate, and St Louis Fed President James Bullard said he wouldn’t “rule out†a 0.75% increase in the Fed funds rate at some point. Higher than expected inflation readings in recent business sentiment surveys also prompted investors to assume a faster pace of Fed rate hikes. As a result, market expectations for the year-end level of the Fed funds rate rose from 2.5% to 2.8% last week, raising concerns about the impact on economic growth.
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Range-bound market
As we have been highlighting regularly, we think equity markets will be somewhat range-bound until investors gain conviction that the Fed will be able to engineer an economic soft landing, or not. Investors need clarity on the following questions: How high will the Fed hike rates? How much will inflation fall? What will economic growth in 2023 look like in the face of a rapid increase in Fed rate increases? It will take some months for these answers to come into focus.
In our base case, we believe that the US economy will avoid a recession. Although economic growth is slowing, it still has good momentum, and the job market remains robust. Rising wages, abundant excess consumer savings, and easy access to capital for businesses and consumers are also supportive. Recessions don’t typically occur when bank lending activity remains solid, as it does today. But we acknowledge the uncertainty ahead and our conviction in the base case is not high enough to have an overweight stance on equities. Still, inflation likely has peaked and lower inflation readings in the next few months will probably be well-received by investors. Our year-end S&P 500 price target remains 4,700. Within the equity market, we suggest focusing on high quality companies and maintaining a balance between cyclical and defensive sectors.
Co-authored with David Lefkowitz, Head of Equities Americas