Cross Asset Strategy
Equity markets continued rallying this week as U.S. economic data held steady, while bond yields remained high. The U.S. CPI report for January came in largely in line with expectations – headline prices grew at a +0.5% m/m pace (+6.4% y/y) and core inflation (excluding food and energy) grew +0.4% m/m (+5.6% y/y). Details of the report told us that the trends we’ve observed in the past months still hold. Goods inflation continued to slow. Shelter inflation remained elevated and contributed to about half of the price increase. Services ex-shelter remained strong given its ties to the tight labor market. This report sent the U.S. Treasury yield curve into a deeper inversion, while equities were largely flat.
On Wednesday equities found support from exceptionally strong U.S. retail sales data. While seasonality factors played a role, most acknowledge that the economy remained more resilient than expected. In our view, this week’s data releases increase the odds that the Fed continues hiking at a 25bp pace until we see clear signs of an economic slowdown. February data – which is usually cleaner than January from a seasonal adjustment perspective – will be key to watch in order to understand if upside risks to inflation and the labor market persist.
In light of the strong performance in U.S. equities since the start of the year, many investors are wondering if the rally is worth chasing. This week’s Strategy Question takes a closer look at the latest earnings results and discusses our favored ways to position.
Strategy Question: Following the weakest earnings season since Q4 2020, how do we position U.S. equities?
With over 70% of S&P 500 companies (by market cap) having reported their 4Q22 earnings, there are a number of interesting observations that can be drawn upon. Heading into the earnings season, market consensus was expecting earnings for the index to be down ~6%, the worst quarter of earnings since 3Q20. Actual earnings are tracking -5.0% in the quarter, or 1% above estimates. This is well below the 1-year (+4.5%), 5-year (+8.6%) and 10-year (+6.4%) averages in terms of U.S. earnings beats and highlights that this has been a relatively underwhelming earnings season. Interestingly, the median company has seen their earnings rise by 2.4% in the quarter, highlighting that earnings weakness is skewed towards the mega caps in the S&P 500. By sector, only four sectors saw positive growth in earnings – namely Energy, Industrials, Real Estate, and Utilities.
However, the price reaction during the earnings season has actually been relatively positive, with the average company that has missed or beat earnings seeing their shares rise. This is not normal, as highlighted in the chart below. We believe that the reason for this is that institutional investors entered 2023 relatively cautious, with light positioning in anticipation of a difficult earnings season, and cautious forward guidance. While earnings were underwhelming, they were not dreadful. This was enough for the more positive share price performance during this earnings season. It is also very interesting that the distribution of these positive share price moves have centered on companies that meaningfully beat expectations (normal), and those missed earnings by the most. The latter group’s positive share price reaction on a poor earnings print likely reflects the view from investors that earnings have been reset enough, and factor in enough risk of a U.S. recession.
There has also been growing consensus that margins need to further normalize back to longer-term levels, which we continued to see in the 4Q22 earnings results. In fact, S&P 500 net margins are now largely back to pre COVID-19 levels and have somewhat reset. In our 2023 earnings estimates, we expect margins to further decline, albeit more modestly from current levels. Our base case continues to call for a normal U.S. recession during 2H, but companies have advanced warning given the consensual nature of the upcoming economic slowdown and are preparing for this by shedding excess labor and expenses. In particular, the mega cap tech names that dominate S&P 500 earnings have started to unwind some of the over-hiring and spending of the last two years in order to protect margins. We expect this focus on efficiency and a lowering of expenses to be a focus of management teams and investors as we progress through 2023. Companies which are able to credibly defend margins and sustain earnings will likely be favored by investors this year.
Overall, the market has made some progress towards resetting earnings estimates for 2023, but there is likely more coming that could extend through to the 2Q23 earnings season.
We favor segments of the market where earnings have already been reset enough and are close to trough levels, and/or where valuations remain reasonable. These opportunities can be found in the U.S. semiconductor sector, and U.S. Midcaps (median S&P 500 earnings were up 2.4% in the quarter), which are some of our most favored segments of the U.S. equity market as we start 2023. On the other hand, with the S&P 500 approaching our 2023 year-end outlook of 4,200-4,300, it is worthwhile considering hedging broader U.S. large cap exposure via derivative structures such as put spreads. In addition, investors could consider switching significant single stock positions into equity structures to obtain some downside protection. Risk management is the key as we expect the broad U.S. equity market to stay volatile.
All market and economic data as of February 16, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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Index definitions
Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.
Standard and Poor's Midcap 400 Index is a capitalization-weighted index which measures the performance of the mid-range sector of the U.S. stock market.
Standard & Poor's Smallcap 600 Index is a capitalization-weighted index that measures the performance of selected U.S. stocks with a small market capitalization. The index was developed with a base value of 100 as of December31, 1993.
Earnings per Share, EPS, the portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.
