This week investors continue to ponder softer inflation numbers, and what they may mean for the economy and markets. On Wednesday the UK also saw a surprise decline in its consumer inflation, leading the 2-year Gilt back below 5%. Sovereign yields across developed markets edged lower throughout the week. The 10-year U.S. Treasury yield is now back at around 3.75%, after an aggressive move higher over the last month. Equity markets continued to grind higher with the start of the earnings season, with the focus moving to regional banks and technology companies in the coming days. To many, the optimism looks premature, as arguably the end-cycle debate is far from settled. But the market has decided to keep its ‘soft-landing’ hopes – so this may well be the path of least resistance until the facts change.
Meanwhile in Greater China, the mood is decidedly more somber. China released a slew of activity data for June and Q2 GDP numbers, which overall paints a very mixed picture. The post-COVID recovery is ongoing, but in the absence of major policy stimulus it is advancing at a slow pace given that the economy is also dealing with a range of other issues – most notably the aftermath of a property slump. In response, analysts are lowering their GDP forecasts for China, again. Evergrande, the poster-child of the boom and bust property sector in China, released its much delayed 2022 financial results, revealing steep losses and elevated debt. The macro and sentiment downturn dragged the CSI300 Index lower over the week, while the Hang Seng Index treaded water. The RMB continued to hover around 7.2, torn between a weaker USD and a slow recovery in China.
In this week’s Asia Strategy Weekly, we turn our focus to the U.S. equity market. Amidst generally positive market sentiment, the Q2 earnings season has kicked off. With an unexpectedly strong market rally this year, the bar is clearly high for stocks that have performed well. As the reporting season ramps up in earnest, this week’s note examines what to expect and how to position.
Strategy Question: What to expect from the upcoming U.S. earnings season
With 1Q23 U.S. earnings growth meaningfully better than expected at just -2% YoY, consensus is expecting a sequential deterioration with 2Q23 earnings to decline -7.5% YoY. However, this is largely due to two sectors: energy and materials – where weaker commodity prices are leading to deeply negative sector earnings growth of -48.9% and -31.7% YoY respectively. Excluding these two sectors, 2Q23 earnings in the U.S. are expected to be flat, which is a sequential improvement over 1Q23. In fact, seven out of eleven sectors are expected to see positive earnings growth this quarter. With recent company commentary at conferences, we believe these expectations are beatable. That being said, the S&P 500 is up ~17% year-to-date, and the bar is clearly higher for stocks that have had very strong performance this year. We will be paying attention to management commentary regarding margins – looking for signs of improvement or new pressures to help gauge potential further market upside. Our expectations are for other cyclical sectors that have lagged the rally to catch up throughout and after the earnings season. The equally-weighted S&P 500 is one way to implement this broadening of the rally in U.S. equities, in our view.
Over the last few months investors have clearly been anticipating a softer landing than what was presented in December, and we’ve seen valuations back to 19x forward estimates. We expect management teams to provide more optimistic commentary than earlier in the year as the labor market has cooled, financial conditions have not tightened considerably, and recession risks appear delayed. Market breadth could come into play and the median stock’s earnings outperformance could translate into better performance in non-mega cap, mid, and small-cap companies. One way we look at breadth is to compare average versus median growth rates:
- 4Q22 earnings dropped -5.5% YoY, driven by mega cap growth, which was down materially, while the median stock’s earnings grew 2.5%.
- In Q1, the average S&P 500 company’s earnings declined -2% – much better than the -6.7% expected on March 31st. However, the median company in the index grew earnings by 1.2%.
- For Q2, estimates call for the average company’s earnings to fall -7.5% and the median company to be flat; we expect a number closer to around -3.5% and +2% respectively.
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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.
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