investment insights
Waiting for guidance: stock markets hinge on China, Fed and Ukraine
Lombard Odier Private Bank
Key takeaways
- First quarter earnings in the US and Europe were sound, but lacked the forward guidance that markets need
- The corporate outlook is clouded by uncertainties around US inflation and the Fed’s terminal interest rate, war in Ukraine and China’s lockdowns
- There are no signs that US inflation has peaked yet, and China’s economy contracted in April
- We focus on value and quality stocks, and maintain put spread strategies to benefit from asymmetric portfolio return profiles.
Will the old stock market adage ‘sell in May and go away’ prove true in 2022? Despite first quarter earnings exceeding expectations, US and European equity markets have dropped by around one sixth year to date. Inflation, China’s lockdowns, the Ukraine war and rising interest rates are clouding the investment outlook. We remain prudently positioned, favouring quality and value stocks to navigate volatility.
Before reporting began, expectations for earnings in the first three months of the year were lowered, setting up companies to beat analysts’ estimates. In the event, companies listed on the S&P 500 index posted earnings per share (EPS) 7% higher, on average, compared with a year earlier, and more than three-quarters beat the consensus for sales estimates. In Europe, EPS growth for the EuroStoxx600 are up 45% from a year ago, and sales growth has been strong and in line with the American market. More importantly, corporate managements are reporting that for now, they have not seen rising prices damage demand for their goods and services, and have been able to pass on their higher costs.
Still, without a clear picture of what lies ahead for corporate profitability, beating expectations in recent reporting hardly matters. Year to date, the S&P 500 has fallen 16% and the Euro Stoxx 600 is down 12%, with the euro falling a further 8% against the US dollar. Positive average earnings growth across markets hides that the energy sector and commodities have fuelled the broad market’s earnings, while most other sectors have seen earnings slow. Excluding the energy sector, EPS growth averaged 3% in the US and 12% in Europe, compared with the same quarter a year earlier. The financial sector has also suffered from this cautious investment approach and the same broad lack of economic visibility.
Technology stocks have led the markets’ declines. The Nasdaq Composite index, where tech companies make up around half of the market capitalisation, has fallen 25% in 2022. This is because tech firms’ valuations are undermined by rising interest rate expectations: their business models are built around future growth on their platforms, and so are more reliant on future rather than present cash flows, which are now discounted at higher interest rates. Similarly, other stocks that benefitted from pandemic lockdowns when consumers were more dependent on their technologies to work, play and shop, have also suffered.
Ordinarily, markets focus on firms’ forward guidance. Through 2021, a majority of companies consistently revised their earnings higher, anticipating the post-pandemic boom. In recent weeks, we have seen the number of revisions to corporate outlooks drop far below their historical average. New guidance largely depends on answering how long supply chains will stay disrupted, and how high US interest rates will rise.
War, pestilence and equities
Most companies will find it hard to make commitments to an outlook for the rest of the year without a view on China’s lockdowns, the new geopolitical paradigm post-Russia’s invasion and an aggressively hiking US Federal Reserve.
The first two of these factors have helped to spur record levels of inflation in the US and Europe and, in response, central banks are raising borrowing costs. The Ukraine conflict looks like a long-term paradigm shift in geopolitical relations, and the chances of a lengthy, drawn-out war are increasing. As a result, corporations are making more permanent changes to their sourcing and distribution chains to take account of intensifying sanctions, Russian economic isolation, and the shift in European energy sources.
Investors are also highly focussed on the Fed’s monetary policy path, and its eventual ‘terminal’ interest rate a year from now. The Fed’s switch from ‘quantitative easing’ to ‘quantitative tightening’ is focussed on removing Covid-era accommodation and fighting consumer inflation, rather than stimulating slowing growth. In addition, the US central bank plans to increase rates at the fastest pace in more than two decades. Before market sentiment improves sustainably, investors will need to be convinced that inflation is moderating, even if it remains at a higher level than pre-Covid. That would let the Fed slow its aggressive interest rate hiking cycle. We are not there yet; US inflation reached an annualised 8.5% in March and 8.3% in April. We expect another 50 basis point interest rate hike at each of the Fed’s June and July meetings, and the benchmark interest rate to reach 3% in 2023.
Slow boat from China
The single most important factor for the global outlook, and therefore for corporate earnings visibility, is China’s slowing economy. The country’s approach to stamping out Covid outbreaks is not only undermining its own economy, but disrupting supply chains as factories halt production and ports stop shipping their goods worldwide.
China’s official GDP growth target for 2022 is 5.5%. That looks increasingly challenged by its zero-Covid policy. Industrial output and consumer spending both contracted in April to levels not seen since the start of the pandemic, while unemployment rose. At best, we foresee GDP growth for 2022 of around 4.3%. Unless the country reverses its current public health strategy, or quickly contains the outbreaks, that may fall below 4% for the full year.
At this stage, it is difficult to see the Covid policy unwinding before the Communist Party Congress later in 2022, when President Xi Jinping is scheduled to have his term in office extended. In the meantime, the government has tried to support the economy with targeted changes including looser borrowing terms for first-time homebuyers. The People’s Bank of China has already been cutting the proportion of deposits that commercial banks have to hold in reserve to increase liquidity.
Valuations and portfolios
While corporate valuations now look more attractive, valuations are not in themselves an investment case and rising interest rates will limit further improvements.
First quarter earnings have demonstrated that corporate reporting cannot save equity markets from negative sentiment and outflows. Three risks are paramount. We expect equity markets to remain volatile until we have greater visibility on US inflation and the US’s terminal interest rate, war in Ukraine and China’s pandemic situation.
We have kept a neutral portfolio positioning on equities along with some portfolio diversifiers and prefer stocks, sectors and regions better able to manage the higher interest rate environment by passing on rising costs, or withstanding lower growth. In particular, we therefore favour the US and UK markets. We focus on value and quality stocks, as well as opportunities in the energy, industrial and materials sectors, along with some quality technology and healthcare names. Crucially, sustainability remains key to every investment decision. In light of the equity market’s downside risks, we have created asymmetric portfolio return profiles, using put spread strategies on US and European indices.
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