David Jane
Premier Miton Macro Thematic Multi Asset Team
With equity markets struggling over recent times and consumers squeezed, talk has moved on from inflation to recession, as we covered in last week’s Perspectives. This week we consider how falling demand might affect corporate profits and hence, equity markets.
Corporate profitability has been exceptionally strong post-pandemic. A combination of sustained demand, due to income support measures, low interest rates and other government programs has helped support consumer demand. Businesses cut back on production, anticipating falling demand, and this meant they were often caught out by the rapid nature of the rebound. Strong demand and increasing prices has meant margins have expanded rapidly. Subsequently, business have rushed to restock, often against a backdrop of rising input costs and supply chain disruptions.
We have now reached a point where consumers are feeling the pinch from rising prices, hence demand is slipping, and businesses are suffering rising costs across the board. This is very concerning for corporate profits. Having seen a massive bounce back, we are now on the brink of a potential mean reversion.
However, market expectations for profits and margins are for them to push ahead to further highs (see graph). This is partly a function of the natural tendency for analysts to project forward past trends and to wait for guidance from management as to what to forecast.
S&P 500 Index earnings and margins including forecast for 2022 and 2023
Source: Bloomberg, 31.12.2012 – 31.12.2023.
What we have seen in the current reporting season is an increasing number of companies warn on sales and margins. In many cases, these companies are in the consumer cyclical area, where margin expansion was particularly strong to rebound and now weakening demand is causing this to revert.
The market reaction is understandable both at the stock level and aggregate. There are two important questions that need to be answered in our opinion: firstly, how far might earnings expectations fall and, secondly, what valuation might we put on those earnings? Regular readers will know we aren’t in the forecasting business, but in this case, it seems reasonable to expect a whiplash effect. Profits sunk below trend during the lockdowns, rebounded strongly to above trend, and now, in our view, must revert back. We believe 2023 forecasts are basically way too high and profits seem likely to fall in that year.
The valuation question is generally considered to be a function of interest rates and inflation. Higher bond yields and higher inflation make for lower valuations. This implies not only do forecasts need to come down, but the valuation on those earnings also needs to fall, potentially leading to further falls in markets.
Hence, all year we have been trying to insulate portfolios to the greatest degree from these twin factors. Firstly, we have been avoiding areas most at risk from inflation, margin squeezes and potential recession. Most obviously this would be consumer discretionary, where we have no equity exposure, and also financials where we have very limited exposure. Industrials is another area of concern, and here we only own businesses with less cyclicality and good inflation protection.
Our approach to avoiding pressure from the valuation squeeze is to avoid high valuations in general and focus on less fashionable areas. Hence, our portfolios could be said to have something of a value bias. We would argue this is largely a factor of our preferred sectors and industries being relatively cheap.
Those areas best able to cope with margin pressures and hence, avoid earnings and valuation declines include consumer staples, utilities and health care in our view. Primary producers such as energy and materials have also been benefitting strongly from the current trends. These areas form the bulk of our equity portfolios at present. We feel we are defensive enough for now but could happily take further action if necessary.
