SCHR - 3 Takeaways From U.S. Earnings

2023-08-17 13:50:00 ET

Summary

• Earnings have been stagnating, and this past quarter, they came in better than feared.
• Heading into this season, I was paying very close attention to if companies are able to keep and maybe even grow their margins, and the answer is yes.
• Looking ahead, headwinds to margins include labor shortage, tight supply as well as sustained wage growth.

Transcript

Earnings have been stagnating, and this past quarter, they came in better than feared.

1) Margins squeeze?

So, heading into this season, I was paying very close attention to if companies are able to keep and maybe even grow their margins, and the answer is yes. But looking ahead, headwinds to margins include labor shortage, tight supply as well as sustained wage growth.

2) Dispersion and selectivity

The second point I would note is this huge dispersion and the importance of selectivity that came through in the earnings picture as well.

So, looking at what has been contributing to earnings upside, we are talking about typically early-cycle sectors like consumer discretionary, for example. Which in the context of labor’s greater share of the pie is not entirely surprising.

I am specifically paying attention to if tech names are able to meet the very high bar as they came into this reporting season. And the answer is also yes, as they surprised versus the even elevated expectations, which is why they continued to hold up in terms of performance.

3) Regional nuance

And the third point I would note is around regional nuance. So, Europe versus U.S. If you look at the absolute year-on-year growth, European equity market versus the U.S., European earnings have contracted twice as much as U.S. equity market this past quarter, which also contributed to European equities losing the relative outperformance earlier in the year, when European exceptionalism was contributing to performance.

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Profit pressure ahead

The dark orange line shows the net percentage of respondents reporting higher average selling prices based on the NFIB Small Business Economic Trends survey. The yellow line shows the share planning to increase worker compensation in the next three months.

U.S. earnings have stagnated over the past year as pandemic-driven spending shifts normalized, squeezing profit margins. Margins ticked up in Q2, so earnings topped low expectations, partly from companies benefitting from lower input costs. We don’t think this will last. The consensus for profit margins looks too rosy - our first takeaway from Q2 earnings (green line in chart). Firms may struggle to pass on persistent labor costs to consumers: the share of businesses reporting higher prices for their products is the lowest since January 2021 (dark orange line), NFIB data show. We see companies facing higher labor costs from lifting wages to attract fewer available workers: the workforce is 4 million smaller than it would have been if it had kept growing at its pre-Covid pace, we find. The recovery of jobs lost in the pandemic has masked what has proved tepid job growth. Competition for workers should boost employee wages - at the expense of profit margins and shareholders.

We believe this structural labor shock is poised to take over as the driver of inflation as the pandemic-driven spending mismatch unwinds. That historic shift in consumer spending during the pandemic to goods from services created mismatches in production and consumption, and within the labor market as a result. It drove up prices and led to fatter profit margins, especially in the goods sector. Recent data showing a further sharp drop in goods prices in the July U.S. CPI and cooling Q2 wage data confirmed spending is normalizing. And that means profit margins are starting to normalize as well, even with the slight improvement in Q2.

Varied results

As worker shortages due to an aging population become more binding, we see firms needing to devote revenue to hiring or retaining workers - to the detriment of margins. We see inflation on a rollercoaster as the labor shock takes over from the spending mismatch. If companies try to protect margins from these wage pressures in a stagnant economy, that could add to inflation pressures and result in even higher central bank policy rates. We have evolved our macro framework to account for these forces.

Our second takeaway from Q2 earnings season: tech met a high bar and selectivity is coming through in earnings. Other sectors that perform well as economic activity picks up fared better than expected, like industrials, communication services and consumer discretionary. As U.S. growth stagnates, it would be logical to question consumer sector resilience - especially as pandemic savings dwindle. But that’s the old playbook: the sector impact may be different. We think workers gaining income share from firms and unemployment staying low could reinforce consumer spending power for some time. We use our new playbook instead to get granular with and within equity sectors. Tech aligns with our preference for sectors delivering earnings growth. But we stay selective in tech with our overweight to the developed market ((DM)) artificial intelligence mega force theme, tapping into this structural shift within DM stocks, even when the macro is unfriendly to broad equity exposures.

Our last takeaway is regional differences. Q2 earnings of European firms contracted twice as much as U.S. peers, contributing to European stocks underperforming DM peers in recent months. Within DM, we prefer equities in Japan, where policy is still relatively easy, real rates are negative and shareholder-friendly reforms are taking root.

Bottom line

U.S. earnings are stagnating. Market expectations for a pickup in margins over the next year look rosy as worker shortages keep pressure on wages. We’re keeping a close eye on the labor market as a result, and stay granular in DM stocks.

Market backdrop

U.S. stocks moved sideways below the 16-month high hit in July, with tech stocks underperforming after their sharp gains this year. Ten-year Treasury yields surged back near 15-year highs after volatile trading, partly due to a weak bond auction. The July CPI showed inflation cooling more. We see inflation on a rollercoaster ride ahead (see above). Market pricing of long-term inflation has diverged from shorter-term pricing, suggesting that markets see inflation pressures persisting longer term.

We’re watching GDP and inflation data across DMs this week. Inflation has returned in Japan but not as much as other major economies. The Bank of Japan (BOJ) is still unsure if higher wages are sustainable and can keep inflation around its target. Yet, the BOJ loosened its yield cap again in July. We see that pulling local and global bond yields higher.

This post originally appeared on the iShares Market Insights.

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