BlackRock’s Weekly Market Commentary: Caution – earnings under pressure

Stocks are rallying as markets believe inflation is waning and the Fed will slow hikes soon. We don’t think the rally is sustainable. Why? We see the Fed hiking rates to levels that will stall the economic restart. Corporate earnings may weaken more as consumer spending shifts and profit margins contract. This is not a typical business cycle, so we expect differentiated regional and sectoral effects. The risk of disappointing earnings is one reason we’re tactically underweight stocks.

Chart of the week

Goods and services split for U.S. economy and S&P 500 earnings

The pandemic and unique restart of economic activity brought about a massive re-allocation of resources. During the pandemic, consumer spending shifted to goods and away from services. That propped up goods producers’ earnings. That’s changing, in our view. Goods demand is weakening. Overstocked inventories, from retailers to semiconductor firms, are evidence of that. Meanwhile, spending is returning to services. This shift could hit stocks.

Why? Earnings tied to goods are expected to make up 62% of S&P 500 profits this year, versus 38% tied to services. See the top bar of the chart. In addition, the stock market isn’t the economy. Goods accounted for less than a third of the U.S. economy in the first half of this year. See the bottom bar. This means a boom in services doesn’t power S&P 500 earnings as much as it does the economy.

Today’s labor market also shows we’re not in a typical business cycle. The labor shortage has been a key production constraint after many people left the workforce during the pandemic. We think higher wages would help normalise the labor market by encouraging workers to return and incentivising employees to stop hopping jobs for more pay. On the flip side, higher wages also ratchet up companies’ costs and pressure margins. These spending and labor dynamics are unfolding as the restart itself sputters. In Europe, the energy shock amid Russia’s invasion of Ukraine will likely trigger a recession later this year, as we said in Taking stock of the energy shock. The restart is stalling in the U.S. as it bumps into production and labor supply constraints, and we believe U.S. activity is now set to contract.

What all this mean for earnings

S&P 500 earnings growth has essentially ground to a halt, we calculate, if you exclude the energy and financial sectors. That’s down from 4% annualized growth last quarter, Bloomberg data show. What’s more, we believe analyst earnings expectations are still too optimistic. There are huge differences between sectors. High oil and gas prices have led to record profits for energy companies. We see these trends persisting for now.

The reason

The West is aiming to wean itself off Russian energy and needs other suppliers. In the long run, high prices and profits could be eroded by the march toward decarbonization. The U.S. Senate passed a bill, called the Inflation Reduction Act, that is likely to shake up the sector. It calls for green energy infrastructure investments and tax benefits to incentivise the transition to net zero emissions.

The investment implications of a weaker earnings outlook

Stocks have rallied as markets price in hopes the Fed will pivot soon. But we’re not chasing the rally. Why? First, market expectations for a dovish pivot are premature, in our view. We think a pivot will come later as the Fed is for now responding to pressure to tame inflation. Second, we see the market’s views on earnings as overly optimistic. Spending returning to services, slowing growth and looming margin pressures pose risks.

Our bottom line

We are cautious in the short run but are staying invested. We tactically prefer investment grade credit over equities because we think it can weather a slowdown that equities haven’t priced in yet. We remain underweight most DM equities on a tactical basis until we see clear signs of a dovish central bank pivot. We like selected healthcare and energy stocks. We are cautious on tech stocks for now due to their sensitivity to higher rates. We do see strategic opportunities in tech and in healthcare as they’re set to outpace carbon-intensive sectors in the energy transition. Within sectors, we prefer quality firms with the ability to pass on higher costs, stable cash flows and strong balance sheets.