1Q22 U.S. earnings and current market volatility
Margins will be key for the earnings story this year.
Global Market Strategist
- Market volatility driven by inflation concerns, possible slowdown due to Fed tightening, and COVID-19 outbreak in China
- U.S. 1Q22 earnings have come in better than expected, with weakness concentrated in consumer discretionary and communication services
- Stock-bond correlations will remain positive for as long as inflation remains sticky
- Multiples will remain under pressure as rates rise, leaving earnings as the key driver of returns
2022 has proven to be a far more challenging market environment than what was expected at the turn of the year. Back in January, a handful of risks could be observed: a more hawkish Federal Reserve (Fed) and higher interest rates, a pandemic that had not yet faded, and inflation that was proving to be stickier than expected. Four months into the year, those risks remain, and coupled with the conflict in Ukraine and fears of slower growth, have contributed to the most significant realized volatility we have seen since 2020.
A re-rating of valuations has led to negative equity returns year-to-date, but importantly, U.S. earnings estimates have continued to trend higher. In an environment of rising rates, earnings will be the key driver of returns; with 95.2% of S&P 500 market capitalization reporting, our current estimates for 1Q22 earnings per share is USD 49.89. If realized, this would represent a quarter-over-quarter contraction of 12.0%, but year-over-year growth of 5.2%. Importantly, 1Q22 earnings have proven to be better than expected, despite the fact that we do look set to realize a quarter-over-quarter contraction in profits.
Against this backdrop, 66% of companies have beaten revenue estimates and 74% of companies are beating earnings estimates, although earnings surprises are tracking below their long-term average. Importantly, profit margins are coming off but are still aligned with pre-pandemic highs. Margins will be key for the earnings story this year. It is rare for S&P 500 companies to see robust earnings growth without profit margins making a positive contribution. As we think about opportunities in the equity market, we are focused on those industries and sectors with the greatest amount of operating leverage. These are companies that can control their variable costs or having the pricing power to raise prices to offset higher costs and protect profitability.
Exhibit 1: Stock-bond correlations
S&P 500 and U.S. 10-year treasury, 12-month rolling correlations, 1900 - present
The most challenging part for asset allocators in the first quarter was that stocks and bonds sold off together. While the past two decades have seen stock and bond prices move in opposite directions, this has not always been the case. As shown in Exhibit 1, stock-bond correlations have been unstable over the long run, and were positive for significant periods from the late 1970s through the late 1990s. This period coincided with elevated inflation and at times aggressive monetary policy, which seems to rhyme with the environment today. Investors may need to rethink what it means to be diversified, particularly if inflation proves more difficult than expected to contain.
That said, an environment of higher inflation may not be bad for active managers. Correlations have been lower and return dispersion has been higher in environments where inflation has been above the median for the full period. The key to navigating equity markets will be to balance earnings potential with valuation, particularly as certain names in the growth space begin to look attractive from a valuation perspective.
Economic volatility has translated into interest rate volatility, which has in turn triggered capital market volatility. As government bond yields move higher, multiples are coming under pressure, but gradually markets will come back into balance. In this type of environment, identifying the sectors and industries which stand to benefit from the broader macroeconomic environment will be key—we like industrials, materials, and energy. Structurally, we continue to see an opportunity in technology and health care.
Markets will remain bouncy as uncertainty around the Fed’s ability to control inflation lingers on the horizon for the rest of this year. However, the path that has been outlined may be effective as global growth shows signs of slowing. The key for a “soft landing” will be how quickly the private sector can recover from the supply-side shock, as healthier supply chains and an increase in labor will help moderate price pressures in the economy.