The sharp year-to-date sell-off in equities has been led by declining valuations rather than a shift in earnings expectations. Multiples on developed market stocks have slipped from close to 20x 12-month forward earnings at the start of the year, to around 15x at the end of May. Over the same period, earnings growth expectations for 2022 have actually been upgraded, from 7% to more than 10%, despite the deterioration in the economic outlook. We look to address the risk that earnings growth disappointment could drive another leg lower in stocks.
History shows that temporary disconnects between economic growth and earnings growth are not uncommon. Earnings growth continued to accelerate as the economy slowed in the recoveries that followed both the dot-com bust and the 2008-2009 global financial crisis, although this trend only persisted for a matter of months.
A closer look at sector-level data helps explain some of the resilience in earnings expectations. Surging energy prices have boosted 2022 earnings growth expectations for the developed market energy sector by more than 60 percentage points; basic materials companies have also benefited significantly from rising commodity prices. Conversely, earnings forecasts for consumer-facing companies have fallen due to growing fears around a squeeze on disposable incomes.
Sector composition has unsurprisingly had a major impact on regional earnings estimates. The commodity-heavy UK market is a prime example where, despite earnings downgrades for every other sector, overall earnings expectations have rocketed, thanks to the significant weighting of energy and materials. While continued support for energy prices appears likely given the protracted nature of the Russia-Ukraine war, we are cognisant that a resolution could trigger a sharp rotation in sector-level earnings expectations.
Some signs indicate that earnings expectations may be approaching a peak. Earnings revision ratios – a measure of the number of analyst upgrades versus downgrades – tend to give a good steer on the direction of earnings ahead. These ratios have been declining since last summer, implying a larger number of downgrades than upgrades. It is perhaps unsurprising that analyst estimates are taking some time to catch up. Forecasters generally like to extrapolate linear growth, yet the past two years have seen a huge “pulling forward” of future demand in some sectors, and a sharp slump in other areas. The rotation away from pandemic trends was clear in Q1 earnings, with several of the “Covid-19 winners” now reporting weakening demand as consumers shift back towards their old ways.
It is important to recognise that stock prices tend to lead earnings, rather than the other way round. Exhibit 7 compares historical drawdowns in the market and earnings. The decline in developed market stocks year-to-date now looks broadly in line with the size of the drawdowns experienced during previous non-recessionary economic slowdowns, despite the fact that earnings downgrades are yet to feed through. Much larger drawdowns have generally coincided with deeper and more sustained economic downturns. The key question looking ahead, therefore, echoes the theme raised in our opening section. We know that earnings downgrades are likely, but how bad might they be?
Exhibit 7: The stock market has moved ahead of earnings expectations
MSCI World earnings and market drawdowns in prior downturns
The resilience of corporate margins will hold a large part of the answer. Exhibit 8 shows the elevated starting point for margins in both the US and Europe, as companies passed on higher costs to their customers during the post-Covid surge in input costs. Supply-chain bottlenecks and tight labour markets were already set to put further pressure on corporate costs coming into 2022, but Russia’s invasion of Ukraine has added an energy shock to the mix. Pricing power will be a key determinant of relative performance going forward; strong pricing power may come from higher levels of operating leverage (which implies a larger proportion of fixed versus variable costs), strong brand recognition that helps make demand less price sensitive, or potentially a lack of competition within a sector.
Exhibit 8: Corporate margins in the US and Europe have remained strong
We expect margin resilience to vary both across regions and industries. The risk of earnings disappointment this year looks larger in the eurozone than in the US, in part due to the greater presence of resource and raw material-intensive sectors in eurozone indices. The earnings risk would be particularly acute in the event of energy supply disruption, although further downward pressure on the euro would offset this somewhat. In the UK, large-cap indices are seeing a boost from higher energy prices at a time where more domestically focused stocks are under pressure from a squeeze on disposable incomes. On the consumer front more broadly, companies that are exposed to higher income cohorts may fare better than those that are more sensitive to spending from lower income groups, where higher food and energy prices will absorb a much larger share of total spending.
In sum, while earnings expectations always take some time to reflect the evolution of the economy, the lag is perhaps more understandable this year given the unique circumstances of this recovery. We do expect analyst downgrades ahead, but market moves are already consistent with a modest slowdown in profits. Provided our central macro scenario plays out, corporate earnings across developed markets should keep growing in 2022, albeit by less than current expectations. We will be keeping a close eye on margins for signs that pricing power is being eroded.