In recent quarters, US companies handily beat consensus earnings estimates as the economy reopened and earnings were compared to the weakness in the 2020 lockdown periods. This neat showing was always going to be a tough act to follow, particularly as bottlenecks have hampered supply. Margin pressures have been the result, leaving investors to focus on profit warnings.
So far at least, those market worries have proven misplaced. Companies in the financials sector have been grabbing headlines with earnings that have been more than 40% higher than a year ago, and 20% better than expected.
But it is not just financials that have bettered analysts’ estimates. To date, more non-financial companies have reported than financials, and results for these companies are 35% higher than those in the third quarter of 2020, although this is ‘only’ 5% more than was forecast (see Exhibit 1).
Positive guidance dominates despite poor macro data
Profit warnings have been a minority. In the second quarter, more than twice as many companies raised their guidance for future results as lowered it. So far this quarter, the ratio has fallen, but only to 1.8x positive to negative, which is still a high number.
These earnings reports are coming amid what is arguably still disappointing economic data (see Exhibit 2).
- China’s GDP growth and industrial production figures came in below forecasts, although retail sales were better.
- Sentiment surveys from Germany showed waning consumer confidence.
- US industrial production was less strong than expected, and the housing market appears to be slowing. One indicator that is rising is inflation, which may be contributing to the fall in consumer sentiment.
As a result of these disappointments, analysts’ expectations for US GDP growth in the third quarter have been cut sharply. Just three months ago, the Atlanta Fed’s GDPNow model was forecasting 6% growth; the current estimate is just 0.5%.
Equities – Eyes forward
Equity markets, however, are focused on the future. While the resumption of normal activity is proving more difficult than expected, we believe the kinks in global supply chains will eventually be worked out.
Labour supply may be permanently lower in the future, however, as many people decide to exit the labour force, particular those around retirement age. This will add to the inflationary pressures, but companies facing shortages will increasingly substitute capital equipment for labour.
Another support for equity markets has been the behaviour of interest rates. Since the lows of early August, 10-year US Treasury yields have risen by nearly 50bp. Through the end of September, longer-term inflation expectations had not risen despite widespread concerns about inflation becoming less temporary.
Flat inflation expectations meant that real yields were behind the increase in nominal rates, which posed a particular challenge for long-earnings-duration growth stocks. More recently, inflation expectations have picked up, while real yields have fallen.
- Equities generally rise along with higher inflation thanks to growing revenues.
- The impact of real yields tends to be the opposite. This is because they reflect both the expected (higher) level of policy rates (which drives the discount rate on earnings), but also (slower) GDP growth expectations (which drives earnings).
Equity markets are assessing the positive impact on nominal earnings of inflation, the negative impact on earnings from slower growth, and offsetting both factors by a lower discount rate. For now, at least, the conclusion is that stock prices go higher.