Reporting season: strong results, but little fresh momentum expected
So far, corporate profit reports have proved a reliable source of support for the equity markets, but the momentum behind global profit growth is waning. Companies with strong pricing power, in particular, remain able to achieve solid results and margins despite rising input costs. This means that company-specific factors are gaining in importance.
The equity markets have already had to cope with a lot in 2022. The war in Ukraine, a spike in the oil price to well above US$ 100 per barrel, close to double-digit inflation rates and hawkish behaviour from the central banks have been weighing on share prices. Nonetheless, the global stock markets are only around 7–8 per cent down on their all-time highs. Corporate profits have been a crucial source of support. After all, companies have largely been performing well in spite of the various adverse influences – at least until now. The reporting season for the first quarter of 2022 is now under way and it is hardly surprising that market participants are keenly awaiting fresh news from the corporate sector.
Global earnings revisions at an 18-month low
Despite all of the current uncertainties, the profit forecasts of global equity market analysts have barely changed since the start of the year. However, this masks the fact that conditions differ significantly between sectors and investment styles below the surface. In addition, global earnings revisions are now at an 18-month low, which reflects the diminishing economic momentum (as measured by purchasing managers’ indices, for example) more clearly. Earnings revisions are defined as the difference between upward and downward adjustments relative to total forecast adjustments, and they often indicate trend shifts earlier than the ‘regular’ profit forecasts. The clearest indication is emerging in the eurozone, where the drop in revisions has been much more noticeable than, for example, in the US. One reason for this is weaker economic growth in the eurozone, but another factor is that the region has also been hit harder by the sharp rise in commodity prices. Both factors are linked, at least in part, to the war in Ukraine and its repercussions, which are milder in the US.
Earnings revisions differ significantly
At sector level, expectations have weakened particularly strongly with regard to the automotive industry and household goods. The European banking sector is also facing a clear downward trend in revisions. By contrast, the energy sector is – unsurprisingly – a positive outlier. Soaring prices for oil, gas and similar commodities mean that forecasts have mostly been adjusted upwards here. Circumstances that are weighing on profits in some industries are thus simultaneously boosting profits in others.
Focus on input costs and pricing power
In the current reporting season, input costs will therefore be a factor of particular interest. Many companies are practically unable to escape the effects of rising energy prices. Consequently, what matters now is the extent to which companies may have been able to mitigate this rise and, in particular, whether they are able to pass the increase in costs on to their customers. In this respect, too, we are seeing very pronounced sectoral differences. Companies in the real estate market, the pharmaceutical sector and the software and semiconductor industries are typically well positioned to pass on higher costs. In addition, commodity prices are less relevant in these sectors, whereas wages are a key parameter. Companies in cyclical industries such as the automotive sector and the retail sector, however, typically have less pricing power and are additionally struggling with supply shortages and weaker economic growth in the current environment.
Rising wages are another important factor. On average across all industries, for example in the US, the cost of commodities accounts for around 14 per cent of total costs while wage costs account for 22 per cent. This means that sooner or later, booming US labour market conditions will hit the companies’ income statements. But, once again, some industries will be more affected than others. Swings in wages tend to have a particularly strong impact on margins in the retail and service sectors, while the energy sector and the semiconductor industry are usually less affected. Europe will not see much of these effects at all yet as upward pressure on wages is less intense there than in the US.
Higher costs do not necessarily mean shrinking margins
Among those companies that are able to pass on rising input costs, historical data reveals an interesting pattern. As a rule, corporate profits actually tend to be positively correlated with rising commodity costs to a certain degree. This unexpected finding is linked, in part, to higher profits in the energy sector. But other sectors have also proven able in the past to use their pricing power to improve their margins. During periods where the two-year break-even inflation rate (market expectation of inflation) was above 2.5 per cent, share prices of companies with strong pricing power outperformed those of companies with weaker pricing power by nearly 14 per cent over the following 14 months. And we are currently still in such a phase.
Good results for Q1, but little fresh momentum expected for equity markets
Against this backdrop, Union Investment does not anticipate a slump in profits. On the contrary, economists at Union Investment estimate that corporate profits will rise by nearly 8 per cent globally over the year as a whole. Results published for the first quarter will probably exceed expectations slightly. But the tendency of companies to remain somewhat non-committal about their outlook in light of the prevailing uncertainty is likely to have a negative impact. This lack of transparency results in reduced predictability. Fresh momentum in the equity market will thus probably be relatively meagre. In this environment, better-than expected performances will see less of a reward.
The first wave of results has confirmed these assumptions. French luxury goods manufacturer LVMH, for example, exceeded expectations in the fashion business, a crucial segment for the company, but did not see any significant uplift in its share price. Idiosyncratic challenges are also likely to increase. US bank J.P. Morgan, for instance, has reported issues in the investment banking business. The relevance of company-specific factors for investment performance in the equity market is thus set to increase again in the coming weeks.
As at 14 April 2022