We think earnings offer little support – expectations for this year are still too rosy. We think corporate margins could get hit by higher costs and reduced pricing power as goods shortages ease. We see an earnings hit on top of that from recession as central banks fight sticky inflation – and are poised to hold rates higher for longer. We prefer short-term bonds for income and emerging market (EM) equities.
Profit margins at risk
Global equity forward profit margins, 2005-2023
Source: BlackRock Investment Institute, with data from MSCI and Refinitiv Datastream, March 2023. Notes: Chart shows MSCI World 12-month forward earnings divided by 12-month forward sales.
We are not in a typical economic cycle. Tight labour markets are driving persistently higher inflation. That’s why we see major central banks creating economic damage and recession as they try to bring inflation down to their 2% targets. We think this is a tough backdrop for earnings – and could get worse as profit margins are squeezed. Companies’ pricing power had increased as the pandemic-driven demand for goods created shortages. But now spending patterns are normalizing back to services and away from goods, so that pricing power is waning. This comes just as cost pressures are mounting from higher wages and funding costs. We expect a recession to hit sales and higher costs to pinch margins still near historically high levels. See the chart. That should crunch corporate earnings and is why we think the consensus for flat earnings in the S&P 500 for 2023 as a whole is still too optimistic.
Good economic news – as seen in the February U.S. payroll gains, confirming a tight labour market – only adds to the risk that central banks will push policy rates even higher and keep them there, we think. This is an important lens through which we see the new regime of greater macro and market volatility playing out – and why good growth news could actually be bad news for markets.
Sector lens
We prefer short-term government bonds offering attractive income over developed market (DM) equities given the risks we see to earnings. Equities are starting to better price in the economic damage we see ahead. Yet we think being selective is key. We prefer the energy sector as tight supply buoys energy prices. We also like healthcare for its defensive characteristics in a downturn and financials due to higher rates and profit margins – even with potential risks. The U.S. stock market’s concentration of tech and consumer discretionary companies make it more exposed to the wage pressures from a tight labor market, in our view. Earnings results from the fourth quarter of 2022 showed revenue growth slowing, and earnings contracted for the first time since late 2020. Both managed to top already lowered consensus expectations – but the earnings beat was the smallest in a decade, we find. We think this shows how inflation can hit earnings – especially with pressure from higher costs related to wages.
European companies face similar constraints in the labour market. Yet we see some support for European stocks because of a large concentration of financial and energy companies we like. We also think the consumer discretionary sector in Europe is set up to benefit from higher demand for luxury goods from China’s economic restart.
Emerging over-developed markets
China’s restart is also an important reason why we prefer EM stocks over DM. We think it helps brighten the overall economic backdrop in EM compared with DM economies. We also think risks are better priced: EM central bank rate hiking cycles are closer to their peak, and the U.S. dollar is still broadly weaker from its 2022 peak – even with its strength this year.
Our bottom line
We think markets are waking up to the risks from the fastest rate hiking cycle since the 1980s. For now, we like short-term government bonds for income. We’re overweight EM stocks and prefer them to DM peers: We think risks are better priced in EM. We’re modestly underweight DM stocks. We think earnings expectations are still too high, so we look for granular opportunities in sectors instead.
Market backdrop
U.S. stocks fell more than 4% last week and erased most gains for the year after Fed Chair Jerome Powell suggested it could pick up the pace of rate hikes and financial cracks emerged. We think the market is also starting to reflect the economic damage stemming from the rapid rate hikes of the past year. U.S. two-year yields fell sharply after hitting 16-year highs to price out rate hikes. We think rates are headed higher and the inflation problem for central banks remains the same.
The U.S. CPI inflation data for February will be a critical gauge ahead of the Fed’s policy decision later this month. Markets are waking up to the risk that rates could stay higher for longer as labour market tightness persists and core inflation proves sticky. In Europe, the ECB is likely to raise rates by 0.5% to 2.5%, and we’re watching for updated economic projections.
