(Bloomberg) — A looming recession, runaway inflation, an energy crisis in Europe and a euro that’s sunk to near parity with the dollar: corporate earnings worldwide face a laundry list of challenges this season that could create another reason to dump stocks.
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Global equities had a turbulent first half, losing $18 trillion. Investors are eager to know if profits are still high or if companies will reduce guidance in light of the growing threat to their business. The dour economic picture may lead businesses to be more conservative about the future than they would otherwise.
In an unusual divergence of opinions, Wall Street analysts appear to believe companies are largely in a strong position to pass on higher costs to consumers, but strategists — more cautious after getting their forecasts for 2022 wrong so far — aren’t convinced. There are plenty of reasons to be skeptical, as the macroeconomic environment is deteriorating with rising prices, higher interest rate and lower consumer sentiment.
“It’s bizarre that when everyone is talking of a potential recession, analysts’ earnings forecasts have been going up in the last few months instead of down,” said Anneka Treon, managing director at Van Lanschot Kempen. “It just doesn’t add up and that’s why this earnings season is so important in terms of profit margins and management commentary on the latest demand trends they are seeing.”
Energy is expected be the dominant sector, as both oil producers and miners have benefited greatly from the surge in prices during the war in Ukraine. After oil prices fell back to $100 per barrel, giants like Exxon Mobil Corp. or Shell Plc will still be crucial. Higher commodity prices also mean higher energy bills for all other sectors, which can have a negative impact on earnings.
While net margins are still at or near their all-time highs of 5%, there are some cracks. A Citigroup Inc. Index shows that global earnings downgrades now outnumber global upgrades at an increasing speed.
With sentiment among stock traders already gloomy, here are five things investors are watching in the second quarter-earnings season that may determine whether there’s a rebound or a drop to new lows.
Inflation Damage
According to Morgan Stanley, luxury goods companies are in a strong position when it comes to pricing power thanks to strong demand. Kering SA, Gucci’s owner, increased some prices by 7% last month compared to February. However, this could be under pressure if managers comment suggests that sentiment is dropping and lower demand.
That’s a worry across the consumer sector. The constant drumbeat of recession warnings might eventually cause a shift in household behavior. It could limit pricing power as well as the ability to protect margins. Investors believe that megacap technology companies, with their large scale, are better positioned than smaller firms to absorb and maintain growth.
Marija Veitmane is a senior strategist at State Street Global Markets. She stated that consumers are choosing to cut down on their food costs and opt for staples with lower margins. Companies that sell to the mass-market will be the most vulnerable.
Even banks, which generally benefit from rising real yields, will find it hard, Veitmane said, as “the flatness of the yield curve could negate the benefits of rising interest rates and keep net interest margins low.” Not everyone is bearish on the sector, however, with top fund managers at Amundi SA and BlackRock Inc. saying last month that European banks in particular were attractive.
The ‘R’ Word
With the slump in stocks coinciding with a recent decline in Treasury yields and weaker oil prices, investors have already positioned for a “recession trade.”
They may be keen to hear what companies have to say about the rest of the year, but they’re already hoarding cash and hiding in bonds. The week ended July 6, and nearly $63 billion went into cash. Global equity funds saw redemptions of $4.6 trillion.
Ken Langone of Home Depot Inc. stated Wednesday that the US was already in recession and added to the list of similar views.
“Some companies might use the general gloom as cover for any bad news that’s been lurking in the shadows,” said Danni Hewson, financial analyst at AJ Bell.
Thomas Hayes, chairman at Great Hill Capital LLC, says that a “kitchen sink quarter is certainly possible,” though he noted that more companies would have cut guidance going into the season if that were going to be the case.
China Crunch
China’s preliminary earnings reports, mainly from materials and energy companies, have been encouraging. However, this season will require close scrutiny of the areas most affected by the virus-related curbs. Haitong Securities analysts Xun Yugen said that earnings estimates for mainland-listed businesses were reduced in the first five months of this year. This reduces the implied profit growth to 22% from 31% for 2022.
According to Northeast Securities analysts steel and construction materials are likely to be among those in the backwaters because of slow property sales and delays in building, while Covid restrictions could have a significant impact on consumer firms.
These measures also affect US companies such as Canada Goose Holdings Inc. and Starbucks Corp. Nike Inc. made a downbeat forecast for the full year in late June, citing China’s closings. The ripple effects of China’s factory closures can also affect supply chains and availability of raw materials.
Europe’s Energy Problem
Earnings at S&P 500 energy companies are expected to have more than tripled in the second quarter, according to data from Bloomberg Intelligence. That compares with an average of 4% for all S&P firms.
Although oil prices have recently weakened again, strategists at JPMorgan Chase & Co. and UBS Global Wealth Management remain bullish on the sector.
However, Europe is spiraling into an energy crisis, with declining supplies of Russian natural gas, and businesses, especially in Germany are worried about power cuts as winter approaches. Pictet Asset Management downgraded euro area stocks due to energy shortage.
The outlook for the region’s utilities is also grim, and governments are taking drastic measures. France is preparing to nationalize Electricite de France SA. Germany is currently in discussions with Uniper SE regarding a rescue package.
Euro is disappearing
A slump in the euro could cause earnings to plummet for both US and European companies that import heavily. Europe’s companies that could be hurt include utilities and travel and leisure, but export-oriented sectors such as automakers, industrials and chemicals would benefit, according to Joachim Klement, head of strategy, accounting and sustainability at Liberum Capital.
For Germany’s export-heavy economy, though, the tailwind may not be as pronounced because of its exposure to China’s supply chain as well as its cyclical nature. “I fear that the benefits of a weaker euro are going to be overshadowed by the deterioration in the macroeconomic outlook,” said James Athey, investment director at Abrdn.
The US dollar is also on the other side of this trade. It’s gained against all major peers this year, and the Bloomberg dollar index is up 9%. Big Tech companies in America, including Microsoft Corp., have been worried about currency movements. Last month, Microsoft Corp. warned that a stronger greenback could hurt its profitability for the second quarter.
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