As second-quarter reporting kicks off, market expectations are high. Corporate earnings are forecast to have grown by more than 50% from the same quarter a year ago when most of the US was only slowly coming out of lockdown. Even if the actual results fall short of the puffed-up expectations, that high growth rate should be a key support for the equity market.
Investors will be paying particular attention to what companies say about the outlook.
Beginning last year, many companies stopped providing forward guidance, that is, their view on whether sales and profits would be higher or lower than the last time they had spoken with analysts and investors. At the time, the outlook was so uncertain; CEOs and CFOs felt they simply had no basis on which to make a forecast.
Already in this year’s first-quarter earnings season, the volume of guidance had reverted to where it had been pre-pandemic. As it happened, those companies that did provide an outlook tended to be more optimistic. This should not have been surprising given that a company with a positive story to tell is more inclined to do so than a company with a poor outlook. The share of positive guidance averaged just under 25% before the lockdowns, but has more than doubled after (see Exhibit 1).
With earnings growth so strong, share prices have become much more sensitive to changes in interest rates, and particularly to the drivers of the change. The impact on equities of a move in the nominal 10-year Treasury yield usually depends on whether it stems from a change in inflation expectations or in real interest rates.
Inflation expectations have been falling since mid-May as the markets began to appreciate that short-term price increases would not necessarily translate into medium-term inflation. That view was reinforced by last month’s more-hawkish-than-expected Federal Open Market Committee (FOMC) meeting.
This decline has had a significant impact on the performance of value stocks, which have been highly correlated with inflation expectations (see Exhibit 2).
Growth stocks, by contrast, have been driven more by changes in real yields, although the correlation is negative. Real yields peaked last March and as they declined, growth stocks have done well.
Some fixed income investors have found the decline in real yields puzzling. Real yields depend on, among other things, the future level of policy rates and economic growth rate expectations.
After the latest FOMC meeting, near-term expectations for policy rates rose, but medium-term forecasts fell. This could reflect the view that inflation will be lower in the future and so policy rates do not need to be so high; in fact, 10-year inflation expectations have changed very little.
An alternative explanation is that the expected level of growth has fallen. While this is possible, it is difficult to find much recent economic data which would support a significant change in the view on the economic outlook.
This uncertainty makes the meeting of the policy-setting FOMC on 27-28 July particularly interesting. We do not expect any surprises, but Chair Jay Powell’s words will be scrutinised to determine if the Federal Reserve is changing its view on inflation and the timing of any tapering of its asset purchases.
The rise in coronavirus infections due to the Delta variant could lead the Fed to emphasise that the outlook is less now positive than it was a month ago.
Powell will likely reiterate the central bank’s position that inflationary pressures are transitory, even if they have been stronger than expected. Most survey and market-based measures of inflation expectations show that investors accept this analysis. One can even see in some market measures a return to the low-flation outlook we had prior to the pandemic.
Whether June’s FOMC meeting really pointed to a more hawkish Fed, with its forecast of future policy rates (the ‘dot plot’) indicating rate rise,s is debatable. Powell has subsequently de-emphasised the importance of the forecasts. This month’s news conference will be another opportunity for him to clarify the Fed’s view.
Given that there is still a substantial shortfall in jobs compared to pre-pandemic trend levels, ‘substantial further progress’ is still needed before the Fed can be expected to begin to reduce its billion-dollar asset purchases.
The rise of the Delta variant could slow progress on employment further if workers become more reluctant to take face-to-face consumer services roles where much of the shortfall lies. If this happens, it will delay yet further the time when the Fed will move from talking about tapering to initiating it.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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