The earnings debate reminds us of ‘The Tortoise and the Hare’ fable. Everyone tends to assume that prices should follow earnings, only to realise that it is the other way round. The stock market index mimics the tortoise, and corporate earnings mimic the hare. Whenever earnings drop, stock market indices are already there, and vice versa.
Part of this conundrum can be explained with timelines: it takes longer for analysts to cut earnings (let alone for companies to report them) than it takes for investors to trade the respective stocks. However, we still warrant major caution when confronted with the argument that ‘earnings are not discounted yet’, because most of the time they are. Furthermore, whenever they are not and the evidence for a surprising shift in earnings arises, markets react at breakneck speed. For the days ahead, this means that earnings will be bad, ‘really, really bad’ – but everybody knows.
However, the danger of having this wall of earnings reports hit the headlines is that one could miss out on real potential game changers.
US dollar: Further weakness is likely
The obvious candidate these days is the USD, or rather the sharp drop in the currency. If this proves to be a turning point for the medium to longer term, it would trigger the biggest shift in the investment regime in a decade. Of course, the jury is still out, but some pieces of the puzzle are falling into place, especially when it comes to the US macroeconomic picture (see further reading "US economy: The cooling is becoming evident"). With the EUR/USD having reached our previous 3-month target of 1.10, set in February 2023, we are rolling over by raising this target to 1.12.
Communications: What to look out for
While consensus expects flat earnings growth for developed market equities this year, the communications sector already went through an earnings recession last year (2022 EPS growth of -14.5%) and is expected to deliver superior earnings in 2023 (+14.0% vs +0.2%) and 2024 (+16.6% vs 11.3%). Currently, the communications sector shows the strongest relative earnings revisions trend across all sectors. Against this backdrop, we decided to upgrade the communications sector to 'Overweight' from 'Neutral'. Within the sector, we recommend focusing on the large-cap digital advertising companies in the US, and the traditional telecommunication operators in Europe.
Emerging market equities: Asia and Chile in focus
Our expectations of an end to the Fed’s rate hiking cycle and a weaker US dollar outlook could create a favourable environment for equities in emerging markets (EM). Historically, there has been a strong inverse correlation between the performance of EM equities and the greenback. Over the past 20 years, a 1% decline in the US dollar index (DXY) has led to a median advance of 3.4% for EM equity returns. Nevertheless, given the vulnerability to rising US recession risks and widening US credit spreads, we maintain a 'Neutral' rating for EM equities vs. developed markets at this stage. Within the asset class, Asia remains our preferred market due to supportive GDP growth rates and earnings outlook compared to other regions. In Latin America, we upgraded Chile from 'Neutral' to 'Overweight' on the back of an improved macroeconomic backdrop and attractive valuations.
The US economy is showing signs of cooling, with retail sales and manufacturing output falling more than expected in March. Inflation is also cooling, with the headline consumer price index barely rising in March and producer prices falling, largely due to lower energy prices. The cooling of the economy is fuelling expectations of an imminent end to interest rate hikes, which is supporting sentiment in the capital markets. At the same time, weaker demand has the potential to tip the economy into a recession. Signs of banking stress in the US increase the risk of a sharp slowdown in credit activity, which could accelerate the slowdown in demand that is already underway. The cooling economy is fuelling expectations of an imminent end to rising interest rates, which supports capital-market sentiment.
While we think the probability of a recession in early 2024 has increased, there is still a reasonable chance of avoiding a recession. As the US economy and inflation are already cooling and signs of banking stress suggest that monetary policy has moved deeply into restrictive territory, ending the rate-hike cycle now would increase the chances of a soft landing for the US economy.
The latest Federal Open Market Committee (FOMC) meeting minutes suggest that the Fed still feels strong political pressure to signal that it is still fighting elevated inflation with further rate hikes and that it is ready to accept a mild recession. We expect this conviction to wane in the coming weeks, as more economic data points signal a cooling of the economy and a slowdown in credit activity. At the next FOMC meeting in early May, we expect the Fed to move away from its intention to raise the federal funds target range again, which would improve the overall economic outlook.