Investors have oscillated between worries about recession and inflation over the course of the year. This has made it difficult to anticipate how markets will react to economic data or news. Something that is good for growth is generally bad for inflation, and vice versa.
Much of the recent data has indicated slower growth and higher recession risks.
Although many of those who foresee recession were pencilling it in for the second half of 2023, the July purchasing managers (PMI) data from the US and Europe suggest it could be sooner. Both the manufacturing and services indices for several countries came in below 50, indicating contraction. The US services PMI dropped sharply – from 52.7 in June to 47.
The compensating benefit of weaker data is that many in the markets now assume central banks will need to raise interest rates by less than was expected to slow the economy and lower inflation. Over the last six weeks, those expectations have dropped by about 100bp (see Exhibit 1).
Earnings season – Not that bad
The decline in rate expectations has supported equity markets even as the weaker growth outlook raises doubts about the earnings outlook. Analysts remain confident about the prospects for next year.
Excluding commodities, average earnings are still forecast to grow by 12% in 2023 in the US and by 11% in Europe. Such strong growth is inconsistent with recession, however, so earnings estimates will likely have to fall – or a soft landing is truly ahead.
The results from the second-quarter earnings season support the more optimistic view. Although there have been anecdotal stories of disappointments and downgrades, the reports have so far been solid.
The headline figure for earnings growth in both the US and Europe is negative (-3.7% and -3.6%, respectively), but this reflects markedly negative earnings growth in the financials sector. This was expected, although the reports have actually been less bad than expected.
In aggregate, surprises in both the sales and profits reports have been positive and, excluding financials and energy, earnings growth has been reasonably good, rising by 7.4% in the US and 3.4% in Europe.
Investors have been paying particular attention to the guidance from companies about the outlook – especially whether they are lowering it given the widespread expectations of recession.
In fact, the opposite has happened. It is worth remembering that, on average, only 23% of companies typically raise their guidance and 38% lower it. This quarter, positive guidance revisions have been higher, at 34%, and negative guidance lower, at just 35% (see Exhibit 2).
This of course is not to suggest that the medium-term earnings outlook is good. We still foresee meaningful downgrades. It merely reflects the fact that the environment is currently positive, albeit challenging. However, corporate CEOs have no more insight into the future than any of us.
Central banks – Do not be complacent
Central banks have continued to raise rates (by 75bp as expected from the US Federal Reserve and by a surprisingly robust 50bp from the ECB), although the market is increasingly sceptical that they will be able to stick to this path.
By as early as next spring, the Fed is forecast to already begin cutting rates, and the ECB is expected to pause. Such a benign outlook is also evident in inflation expectations. The rate of price increases in the US is forecast to drop to 3.8% in a year’s time and to continue decelerating from there. Whether that reflects the effects of recession or inflation finally proving to be ‘transitory’ is impossible to say.
We believe, however, that the market’s view of the policy rate outlook is too complacent. While growth is indeed slowing, inflation is likely to be sticky for longer, necessitating the rate rises that the two main central banks themselves have laid out.
We have seen already several times this year that when expectations for policy rates rise, equities (and particularly growth stocks) suffer. Despite the good news from this earnings season, equities are likely not out of the woods, and the worrywarts may yet be rewarded.