Materials, commodities and energy deliver while consumer discretionary weakens
Since the start of the year, buy-side investors have been bearish, expecting global profits to worsen significantly. April’s BoA Merrill Lynch Fund Manager survey has pointed to the weakest outlook for corporate profits since the onset of the Covid pandemic in March 2020. Other instances of such low expectations include the collapse of LTCM, the Dotcom bubble bust and the Lehman bankruptcy.
On the sell-side, the mood has been less grim. Earnings revisions to future profits have been largely neutral with some notable divergences — strength in the energy sectors and weakness in consumer discretionary. Sales revisions have been holding up better than earnings per share (EPS), pointing to cost concerns rather than a loss of revenue momentum. This is not entirely surprising as higher inflation can translate into faster revenue growth, if companies have pricing power.
Chart 1: S&P 500 sales revisions holding up better than EPS — pointing to cost, not top-line concerns
Source: Refinitiv, May 2022
Are companies beating or missing estimates?
First quarter EPS delivery has been solid with strong and broad-based beats, although there is moderation from the exceptional period of profit rebound during the post-Covid recovery.
US earnings are beating estimates by 6.7%, with 79% of companies topping projections. (This compares to a long-term average of 66% and prior four-quarter average of 83.1%.) Three-quarters of companies have reported first-quarter revenue above analyst expectations. (Compared to a long-term average of 61.6% and an average over the past four quarters of 79.5%.)
The picture in Europe has also been positive with above-average positive surprises on both EPS and sales estimates. Basic materials have delivered the biggest beats.
What key sectors are seeing a change in earnings?
Commodities and energy were both strong — a double-edged sword, as this means higher input costs for producers and an income squeeze for consumers (especially in the US where fuel price has a greater impact on wallets).
Banks lost momentum in EPS, due to the demanding comparison base from last year when they made one-off gains writing back provisions for bad loans during the pandemic.
The consumer discretionary sector is under pressure, especially in areas with little pricing power and high operating leverage. Retail sales in the UK are weak due to falling incomes, so earnings season has been disappointing for consumer discretionary names; only 57% of names surpassed expectations versus 79% for the S&P 500 Index. Earnings revisions are negative.
Chart 2: Energy and consumer discretionary earnings have been negatively correlated (53% correlation)
Source: Refinitiv, May 2022
Pandemic beneficiaries seeing the tide go out include Netflix and Peloton, as consumers migrate from online services back to physical ones. Investors have realized the growth of some companies was super-charged during the pandemic and may not be sustained. Although stock-pickers will want to look for the winners with resilient structural growth, good pricing power and customer loyalty.
What’s the forward-looking guidance?
In the US, profit warnings have outnumbered positive pre-announcements by a significant margin. This contrasts with the post-pandemic period when corporate guidance was revised meaningfully higher.
Europe has also seen fewer companies positive on outlook, but with no major cuts to guidance yet. Uncertainty around China and the impact of the Russian invasion of Ukraine are weighing on European stocks. The analysis of words included in quarter-one corporate transcripts points to rising uncertainty and falling optimism.
After almost two years of strong upgrades to future earnings, we may be at a turning point. The dispersion in estimates is rising and while overall revisions are still neutral-to-favorable, the rise may signal a weakening outlook.
After almost two years of strong upgrades to future earnings, we may be at a turning point.
Across much of the developed world, corporate margins have been rising ever since the great financial crisis. Margin improvement accelerated during the post-Covid recovery. But we are now seeing the first signs of margin contraction as rising input costs, supply-chain constraints and labor pressures erode profitability. For now, as evidenced by the strong first-quarter results, corporates have been able to pass on those higher costs and grow earnings, but this may not be sustainable.
From here on, the trajectory will depend on growth and inflation. Slowing growth and rising inflation will likely erode profitability. This does not necessarily mean a collapse in corporate earnings (periods of EPS contractions are typically associated with recessions), but could mean a significant deceleration in the rate of EPS growth.
There is no question that the best of profit growth is now behind us and the risks are increasingly skewed to the downside.
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