Rudi's View | May 12 2022
In this week's Weekly Insights:
-Trend Is Turning For Corporate Profits
-No Weekly Insights Next Week
By Rudi Filapek-Vandyck, Editor FNArena
Trend Is Turning For Corporate Profits
First came the bond market rout, because the Federal Reserve conceded it had waited too long to tackle inflation and thus portfolios globally needed a major reset.
Cue the January sell-off which in particular hit yesteryear's champion performers, i.e. technology, growth, quality and low-volatility defensives.
The Fed's about-face also triggered the worst performance for bonds... ever? Arguably, with all major US equity indices down double-digits year-to-date, a bear market is unfolding for both bonds and equities which is exactly what happened back in 1994.
Back then, the Federal Reserve was equally in accelerated tightening mode to combat too-high inflation.
Once the Fed was done, and inflation had been tamed, there followed no recession and equity markets globally embarked on a strong up-trend that would only be interrupted by a hedge fund debacle (LTCM) and the Asian currency crisis, until the TMT/Nasdaq bubble burst in March 2000.
Equity investors and commentators are by default optimistic and positive, so many will be counting on a repeat of the post-1994 era, which is possible, though not a guarantee.
Either way, first markets have to shrug off the tail-end of this year's bond market abyss and inflation scare; meanwhile the focus already is shifting to the consequences of accelerated central bank tightening, which might well end with the next economic recession. Consumers are now leveraged to low rates and housing is an important driver for most economies.
Within this context, it's probably not wise to focus on current corporate earnings reports or still firm looking economic data and indicators. Accelerated rate hikes in the US combined with quantitative tightening (= reduced liquidity) amounts to what could well turn out to be the biggest leap in tightening ever undertaken by any central bank in such a short period.
This is the true meaning of "aggressive tightening", a policy-stance that has become necessary in 2022 because inflation is (way) too high for comfort, and central bankers have by now lost confidence it will deflate by natural forces alone.
The scenario only few are willing to talk about in the world of equities is that if inflation now sticks around for longer, the only way to bring it back down to acceptable level is through economic contraction, i.e. a recession.
It may yet take a while before investors can confidently assess whether a US recession can be avoided, or not, but shorter-term the focus is shifting to the deteriorating outlook for corporate profits, on the back of stubborn inflation, slowing growth and still plenty of interruptions and sectorial headwinds.
The US leading the way?
In the US, more than anywhere else, business leaders have refined the art of beating market expectations. In just about every single reporting season, and they have four each year, the aggregated statistics are stunningly good. The current season over there is no exception with all 11 sectors beating consensus forecasts thus far.
Despite the market's scepticism, and various harsh punishments in case of major disappointments, the consensus EPS forecast for this year has actually risen by circa 4% since the start of April. At face value, this has created an odd schism between weak share prices and bearish market sentiment whereas corporate profits are actually better-than-expected and forecasts in aggregate are still rising.
But don't be fooled by what the situation looks like on the surface. More experienced market analysts warn there is a lot of smoke and mirrors happening and recent, in-depth analysis by BofA Securities suggests the running season instead is shaping up as a turning point in trend, for the worse.
Take the energy sector out of the calculation, says BofA, and the underlying trend is already slightly negative. On BofA statistics, both ratios for companies providing forward guidance and for analyst revisions to earnings are running at their lowest level since the second quarter of 2020 - at the height of the then freshly-arrived covid pandemic.
BofA has developed its own natural language processing (NLP) analysis which reads earnings calls transcripts while measuring overall sentiment via the language used by corporate leaders.
This proprietary piece of insight equally suggests the underlying trend is back to where it was in Q2 of 2020. On a year-to-year basis, report the analysts, this season's plummeting NLP sentiment score marks the biggest drop outside of the GFC and covid recessions.
History shows such a sharp deterioration in sentiment indicates US earnings growth is about to get a lot worse - not something that is currently assumed in analysts' forecasts, including BofA's. And equity markets tend to follow corporate earnings, both during up-trends as well as when the trend deteriorates.