Macro events overshadow a positive earnings season
With macro events dominating the headlines (Ukraine, Fed, oil), along with a high-profile “blow up” or two (i.e., Meta, PayPal), it is perhaps not surprising that there has been less attention lately on the overall Q4 earnings season results. And while almost any earnings season might seem disappointing after the string of blockbuster quarters from late 2020 through 2021, the reports for Q4 2021 have in fact been reasonably good overall. Thus far, the company guidance has been sufficiently supportive that analysts are still raising estimates for this year and next, a contrast to the usual pattern of trimming calendar year estimates over the course of a year.
Shifting to neutral on equities
Our intermediate-term (3-6 month) indicators have deteriorated enough recently to argue for shifting from overweight equities in our asset allocation framework to neutral. While stocks are still favored over bonds on a longer-term relative valuation basis, the prospect for further consolidation and volatility means that easing back equity exposure and holding somewhat more cash makes sense in our view.
Sector estimate revisions led by Technology, Energy, and Real Estate
Earnings estimates in the US continue to rise overall, helped by the continued solid economic backdrop, but the pace has eased from last year’s extraordinarily positive levels and divergences among sectors are more visible now.
Part of our sector analysis includes monitoring the aggregate earnings estimate revisions trends for the 11 GICS sectors as well as the more granular industries (we track 62 in the US currently). One of the key metrics is what we call “revisions breadth”, which is the net proportion of analysts covering a stock who have most recently raised their earnings forecasts versus those who have lowered estimates. Thus breadth readings can theoretically range from +100% (if all analysts are raising estimates) to -100% (if all analysts are reducing estimates). Thus higher is better on revisions breadth as it indicates the fundamental news is broadly improving within a sector.
Stay with large-caps as volatility picks up
In our view, equity markets have been shifting toward a backdrop of higher volatility and thus more modest gains relative to the last 18 months. After an all-time high in early January, the S&P 500 recently endured its first 10% decline since September 2020 before rebounding sharply in recent days. This pickup in volatility is consistent with the pullback in fiscal and monetary stimulus, and the natural development of the economic cycle. Bonds are still unattractive on a relative valuation basis compared to stocks, but market and macro conditions are no longer as lopsidedly in favor of stocks as they have been.
Volatility returns as investors adjust to policy outlook
Equities, and asset prices in general, have seen a return of volatility during January, following over a year of very subdued volatility and strong returns. Why, especially in a historically favorable seasonal period? In our view, markets are adjusting to the indications of moderately tighter monetary and fiscal policy following a period of extraordinary support from both US macro policy drivers. Investors are debating whether policy makers will be able to reduce stimulus and inflation pressures without provoking excessive economic weakness, and this debate is showing up as volatility in markets.
Macro uncertainty is provoking volatility
Rate policy diverging among global central banks
Central bank policy remains a key focus for investors as rates are set to rise in the US this year, with debate about the pace of the rate hikes and balance sheet adjustment ongoing. However, this is not true everywhere, as there have been growing divergences in expected rate policies among the major developed market central banks.
As shown in the chart below of two-year sovereign bond yields for the US, UK, Japan, and Germany (Eurozone), investors are pricing in multiple rate hikes over the next year or two from the US Fed and the Bank of England (BoE): US and UK two-year yields are at or near 1% now, up from around zero for most of the time since early 2020.
Does Tech reliably lag when yields rise? No
We often hear the narrative that rising long-term bond yields are harmful to valuations of “long duration” Growth stocks, especially the Technology sector that dominates the Growth style. This has been evident in day-to-day swings in the market recently.
While we understand the concept embedded in discounted cash flow models that higher discount rates depress current equity values more when capitalizing earnings that occur further in the future, we have been skeptical that the discount rate effect in most cases is sufficiently large to dominate changes in growth expectations or investor risk tolerances, at least for the Tech sector. In other words, our view has been that an investor’s bigger concerns when evaluating higher-Growth Technology stocks are the future earnings growth rate and the risk involved, not whether Treasury bonds yield 1.5% versus 2%. Changes in growth expectations and investor risk perceptions will typically have much larger effects on stock prices than moderate changes in Treasury yields, especially when interest rates (and real rates in particular) are at such a historically low level.
Earnings expectations for 2022
With 2021 now in the history books, earnings reporting season for Q4 and the full year is set to begin soon. Below we update the current consensus earnings outlook for Q4 as well as the coming year for the S&P 500. We also drill into expectations for sector earnings growth for this year.
The bottom line, so to speak, is that analysts expect solid but more moderate growth in earnings of about 9%, led by gains in the Industrials and Energy sectors, with Financials and Real Estate the only sectors expected to show declines in earnings this year.
That’s a BIG Apple
There have been a number of headlines recently highlighting the extraordinary market capitalization being awarded to Apple Inc. (AAPL), which has retaken the title as the world’s most valuable publicly-traded company.
The company’s value is now approaching $3 trillion, a level that places it not only as the largest individual company ever on public markets, but would rank it among the largest stock markets.
Energy sector supported by recovering output and elevated prices
We remain overweight the Energy sector, as analysts continue to raise earnings estimates and the sector is very favorably valued, though the picture has become somewhat more mixed as crude oil prices have been volatile recently. News of the new Omicron variant of COVID-19 and corresponding constraints on international travel have renewed concerns about fuel demand, while OPEC’s decision to go ahead with output increases has reduced the earlier concerns about insufficient supply.