Corporate earnings held up reasonably well in the second quarter, but there are increasing jitters about their direction from here. Could earnings weakness prompt markets to lurch lower?
- The BlackRock Investment Institute says it worried about corporate earnings deterioration
- The recent earnings season was more upbeat than many had expected with 75% of S&P 500 companies beating expectations
- The recent market rally has left valuations more vulnerable to a deterioration in earnings
In the latest update from the BlackRock Investment Institute, the group said it put no faith in the recent recovery in markets. Its reason? The coming corporate earnings deterioration – the result of a rotation in consumer spending and a stalling recovery. Is it right to be worried?
BII points to some technical reasons why earnings are likely to deteriorate as well as the generally gloomy economic climate. It points out that spending is rotating from goods to services. Services are generally less well-represented in the stock market. It says: “Earnings tied to goods are expected to make up 62% of S&P 500 profits this year, versus 38% tied to services.”
The recent earnings season was more upbeat than many had expected. Factset data showed 75% of S&P 500 companies reported earnings per share ahead of expectations. The earnings growth rate, at 6.7%, was still the slowest rate since the pandemic, but given inflationary pressures, it was a boon for earnings to grow at all.
However, these figures are backward-looking and don’t reflect the substantial economic deterioration since the start of the third quarter. Many companies are reserving judgement on their prospects for the remainder of the year. Of those S&P 500 companies that have issued guidance for the next quarter, 42 have been negative and 30 companies have been positive, in line with long-term averages.
The recent market recovery has been driven by p/e expansion. Investors have reappraised valuations, believing that the Federal Reserve may hold back on further rate rises in the face of weakening economic data. This seems naïve and gives investors less wiggle room on earnings.
Equally, investors need to be cautious on the nature of earnings improvement. Revenue growth may be flattered by price rises as companies seek to recoup higher input costs. This may disguise declining volume growth and make earnings look better than they are.
Almost all market participants agree that the outcomes for individual sectors is likely to be extremely varied and market pricing should reflect that. BlackRock says: “This is not a typical business cycle, so we expect differentiated regional and sectoral effects.” Uncovering those rare companies that can grow earnings through these economic difficulties will be the key to returns in the remainder of the year.
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