11 Apr 2022
The past few months have delivered a number of unwelcome developments resulting in greater risks to economic growth, higher inflation and more volatile markets.
The emergence of the Omicron variant of Covid late last year has weighed on economic activity and prolonged supply-chain disruptions. Persistent inflationary pressures have forced a number of key central banks to take a firm stand against rising prices.
Bond markets have finally responded to tightening of monetary policy, as fixed income investors expect more aggressive rate rises. The rising discount rate, in turn, threatens equity valuations, especially those of longer-duration growth stocks. This has led to heightened stock volatility.
More recently Russia invaded its neighbour Ukraine – a move that could lead to the worst conflict on European soil since World War 2.
In addition to a looming humanitarian crisis, this war has the potential to magnify many of the existing challenges linked to global supply chains, commodity prices, costs of living and financial conditions.
Indeed, even though we’re only just embarking upon recovery, recession risks are creeping higher and policymakers are walking an increasingly precarious tightrope.
In the midst of this uncertainty, companies have just finished releasing their fourth quarter (Q4) earnings results. These give us an important glimpse into the general state of corporate health and, by implication, companies’ resilience to growing obstacles.
Beyond the recent market volatility, the picture gives us no cause for alarm. Some 78% of S&P 500 companies managed to beat analysts’ earnings forecasts, with only 17% disappointing investors.
By comparison, since 1994, the average percentage of S&P 500 companies exceeding expectations is 64%; the average over a more recent time period is 75%.
The average earnings per share (EPS) ‘surprise’ remains credible – +5.3%,. Obviously this is a significant moderation from the double-digit numbers we saw in Q3 2021, but revenues are still higher than expected, although by a smaller margin than during the preceding few quarters.
Chart 1: S&P 500 quarterly EPS surprise vs expectations
Source: Refinitv, IBES, February 2022
There are clear signs that earnings growth is decelerating. That said, there’s no reason to panic because this is an expected development as growth settles into a more sustainable pace.
Profit margins are being squeezed as costs rise due to stronger inflation. The rapid reopening of economies has pushed up demand, while residual Covid restrictions have constrained supply.
This has created a perfect storm, as prices adjusted upwards and various bottlenecks emerged – from factory utilisation to port congestion.
Inflationary pressures mean that we have likely seen most of the margin expansion for this cycle, and future profit growth will largely be dependent on demand outlook and pricing power.
Several developments are creating additional headwinds. The macro outlook has weakened as Omicron continues to cause disruptions. Monetary policy in the US and other developed economies is turning less favourable.
More recently, Russia president Vladimir Putin’s invasion of Ukraine is likely to worsen inflationary pressures – via higher raw material and agricultural prices – and damage overall economic activity.
The outcome of this conflict is highly uncertain and will depend on Putin’s goals, the resilience of the Ukrainian people, as well as the robustness of the West’s response.
Not surprisingly, even before the Russia-Ukraine conflict became front-page news, company guidance turned cautious during the Q4 reporting season.
Companies have limited visibility and increasingly less room to offset rising cost pressures in an environment of decelerating earnings growth. Tightening monetary policy and geopolitical uncertainty may mean that demand, and companies’ ability to raise prices, will be constrained.
Despite fairly limited visibility and quarter-on-quarter deceleration in the rate of profit growth, we’ve also seen encouraging signs of confidence elsewhere in corporate behaviour.
For example, cash generation has been exceptionally strong during this ‘recovery’ period and this has led to an increase in stock buybacks and capital investment. Recent supply chain disruptions have likely speeded up capital expenditure plans.
Not surprisingly, even before the Russia-Ukraine conflict became front-page news, company guidance turned cautious during the Q4 reporting season.
In the absence of a significant escalation of geopolitical tensions, we believe that earnings growth has a good chance of rolling over into this year, even if margins are constrained.
In general, broad-based inflation and a robust medium-term nominal growth environment are supportive of corporate revenue and profits growth.
Healthy nominal revenue growth can offset cost increases and prevent margin compression up to a certain point.
This means the future trajectory of earnings will reflect revenue growth, and not benefit from margin expansion.
Chart 2: Operating margins offer little room for further expansion
Source: Refinitv, IBES, March 2022
Following the strong recovery of recent quarters, further potential profit growth is constrained. We’re expecting it to settle into the mid-to-high single-digit percent range going forward.
However, considerable risks have emerged that threaten to act as a headwind, especially in sectors that rely on commodity imports.
As profit growth normalises, further EPS expansion will grow more dependent upon the sales outlook for companies, as reflected in volume and pricing power. These developments are typical of those seen late in a cycle.
The latest earning announcements have brought some reassurance to investors with regards to the health of the corporate sector, but the storm clouds are gathering.
RISK WARNING
The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.
