Markets Weekly podcast – 24 October 2022

Henk Potts (HP): Hello. It’s Monday, 24th October and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.  

My name is Henk Potts, Market Strategist with Barclays Private Bank. Each week, I’ll be joined by guests to discuss both risks and opportunities for investors.  

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then discuss the outlook for equity markets. Finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead. 

Fortunately, the turmoil in British politics was not replicated through global financial markets last week, though volatility remained elevated as surging inflation, hawkish central banks, and deteriorating economic conditions clashes with solid third-quarter earnings, cheaper valuations, and hopes of an eventual Fed pivot.  

It was a positive week for equity markets. In fact, US stocks outperformed. The S&P 500 rose 4.7%, the biggest advance since the week that ended on 24th June, the highest closing level since 5th October. 

The STOXX 600 in Europe was up 1.3% over the course of the trading week. Treasury yields dipped after the Wall Street Journal reported that some Fed officials want to discuss slowing the pace of rate rises after the November meeting. The policy sensitive two-year yield posted its biggest weekly decline since July. The 10-year yield was back to 4.22%. 

In the UK, sterling has strengthened. This is as investors bet a Sunak administration will deliver the tough decisions required to return the nation’s finances back to a sustainable path. 

In terms of the data, September’s UK inflation report showed consumer prices rose 10.1% year-on-year. The acceleration back into double digits that matches the 40-year high that we saw in July was ahead of consensus, as was the core reading at 6.5%. 

Contributing factors were broad-based. The key contributors were food, at 14.8%, and hospitality, which has been driven higher by accommodation. Service inflation continues to strengthen, with few signs that weaker activity data over the course of the summer is truly impacting firms’ pricing decisions. 

In terms of the outlook for UK inflation, short term, we think inflation will be driven by food, to a lesser extent housing and miscellaneous goods and services. Changes made to the energy price guarantee policy could also, of course, have a significant impact on the inflation profile over the course of the next year, as the new Chancellor announced that the policy will be reviewed in April 2023 and become more targeted. 

If energy prices reverted back to the historical Ofgem formula, we would expect inflation to be back above 10% in April, and stay above 7% through the course of next year. Under this scenario, inflation would be on average 3.6 percentage points higher in 2023, but there’s clearly a vast amount of policy uncertainty ahead of that 2023 Budget. 

In terms of their path of policy, what do we expect for interest rates? The inflation profile remains within the Bank of England’s projections. We‘ve got the fiscal U-turns and the recent strength in terms of labour market data, all of which, we think, is supportive for a 75-basis point hike at the 3rd November meeting, followed by 50 basis points in December. That pushes the expected terminal rate up to 3.5%, but with risk remaining skewed very much to the upside. 

Moving on to China, where the latest growth figures have been published. They show the world’s second-largest economy rebounded at a faster-than-expected rate in the third quarter. GDP grew at 3.9% year-on-year. That was above consensus, which was around 3.3%, and certainly better than that miserable 0.4% growth rate that was registered in the second quarter. 

However, there’s still plenty of evidence that its commitment to a zero-COVID strategy is impacting domestic activity. Retail sales growth slowed to just 2.5%. Unemployment rose and is now standing at 5.5%. The housing market continues to contract. 

If we’re looking for a bright spot, it can be found in terms of industrial production growth, which was up 6.3% in September year-on-year. 

Market reaction? Well, we’ve seen that Asian stocks in yuan have weakened on the update. The Hang Seng, in fact, was down 6.5%, the CSI 300 down 3%. In terms of China’s growth outlook, we think, without a material pivot from COVID containment to management, China’s recovery is expected to remain inhibited, although we would expect to see some improvement from the depressed 2.6% growth rate for this year, to around 4.5% in 2023. 

So that was the global economy and financial markets last week. In order to discuss the outlook for earnings, valuations, and positioning in equity markets, I‘m pleased to be joined Dorothée Deck, Cross Asset Class Strategist with Barclays Private Bank. 

Dorothée, great to have you with us today. The third-quarter earnings season, as we know, has started, although it’s probably a little bit too early to extrapolate any trends yet, but what are the expectations for US and European earnings during the course of this quarter? 

Dorothée Deck (DD): Good morning, Henk, good to be with you. So, yes, the earnings season started a couple of weeks ago, but less than 20% of companies have reported earnings so far, so we can’t really read too much into those results yet. 

We’re now entering the busiest period of the season, with about 60% of companies scheduled to report over the next couple of weeks in the US and Europe. It’s important to flag that in the past three months, third-quarter earnings expectations have been downgraded significantly in the US, across sectors.  

However, in Europe earnings forecasts have been more stable, as they have generally benefited from a much weaker euro and sterling against the dollar, but it generally means that it will be easier for companies to beat lower expectations. 

Results will be particularly difficult to analyse this quarter, because they are heavily distorted by base effects and commodities sectors, and to be more specific, third-quarter earnings are expected to grow by 3% year-on-year in the US and by 28% in Europe. 

If we exclude the energy sector, third-quarter earnings are expected to decline by 3% in the US and increase by 10% in Europe, so that’s a significant difference. Revenue growth is expected to remain healthy, at 7% in the US and 9% in Europe when excluding the energy sector. 

Now, analysts’ forecasts for the next couple of years are still too optimistic. We expect the market to be more discriminating during this reporting season and penalise the companies that miss consensus forecast. Similarly, low-quality beats will probably not be rewarded that much.  

And, actually, we’ve already seen some of that in the past couple of months following a number of profit warnings in the US and Europe. These companies have basically underperformed the broader market by 9%, on average, on the day of the warnings. 

HP: Well, thank you for sharing some of the details in terms of analysts’ expectations and those headline numbers. I wanted to get into a little bit more detail, though, and really start to think about what investors are focusing on this time around. 

DD: So, clearly, pricing power will continue to be a key focus this quarter. Investors will be scrutinising companies’ ability to pass on higher input costs to their customers as demands rise up. EBIT margins remain close to historical highs and margin expectations are still too optimistic. They will have to be revised down. 

Investors will also be watching revenue trends and any signs of weaker demand and rising inventory levels, which obviously have an impact on pricing power. So, as usual, trading outlooks will be keenly watched. 

On the cost side, the market will be paying particular attention to energy and labour costs. Company comments around limits to production will be important, especially in areas such as labour shortages or component shortages. There will also be a renewed focus on leverage and interest coverage ratios following the recent surge in yields, and companies with near-term refinancing needs and thin coverage ratios will be most at risk. 

And finally, following the strong dollar appreciation, currency impact will also be watched. It will be a tailwind for European exporters and a headwind for large US international firms. The most export-oriented sectors typically are consumer staples, luxury goods, autos, pharma, and semiconductors. 

HP: Dorothée, when I look at earnings, there’s now a significant disconnect between analysts’ forecasts, which, as we know, remain optimistic for the coming year, and GDP expectations, which have continued to be downgraded. How much risk do you see to earnings forecasts and what e the implications for equity markets? 

DD: Absolutely, Henk, and we’ve also been surprised by the resilience of the earnings forecast in the face of a very challenging macroenvironment. As you said, GDP forecasts have been slashed across regions, while inflation expectations have been revised higher. And yet, earnings expectations for the coming year only started to come down in July, and only very modestly, but we think there is more to come. 

We expect significant earnings downgrades in the coming months, primarily driven by margins. And the third-quarter reporting season might, actually, be a trigger for this, as early earnings releases indicate that margins are surprising on the downside.  

So, basically, bottom-up analysts are still expecting global earnings to grow by 11% this year and by 5% next year. This is substantially higher than our own forecast of an 11% year-on-year decline in earnings by April next year. 

The good news is that this type of scenario seems to be reflected in the price already. So, on our numbers, equities are currently discounting a 13% decline in global earnings by this time next year, slightly worse than our own estimates. So, to see more downside risk to equity prices from current levels, you would have to believe that earnings will go down by more than 13% year-on-year in the next six months. 

It is certainly possible, as in previous recessions global earnings have declined by 20% year-on-year on average, and by as much as 35% in 2009. In other words, the market seems to be discounting a mild recession. If we were to see an average recession, we believe global equities could go down by an additional 10% from current levels, and that would bring us 35% below the January peak levels. 

HP: OK, Dorothée. Let’s try and bring that together from an investment strategy perspective. As we know, valuations have already come down massively during the course of this year. Sentiment is quite depressed. As we know positioning is also light. Assuming earnings hold up relatively well during the course of this downturn, and certainly compared to other downturns at least, could this form the basis for a market rebound? 

DD: So, for equity markets to bottom, we need to have a set of conditions in place. Cheap valuation, depressed sentiment, cautious positioning, and a sense that we’ve already seen the worst, in terms of economic activity, inflation, and interest rates. Two of those conditions are already in place, but they’re not sufficient on their own to trigger a sustainable rebound. 

Equity valuations have already come down massively on the back of the surging real yields. Sentiment amongst individual investors is very depressed and close to historical lows, according to the AAII survey.  

However, risk appetite measures across major asset classes are more neutral, suggesting that we haven’t seen a capitulation yet. And, with regards to positioning, it is cautious but not extreme yet, or at levels that suggest a positive asymmetry of returns. 

To see a sustainable rebound in markets, we will need to be convinced that the rate of deterioration in economic activity has troughed, that inflation has peaked, and that the Fed and other major central banks have stopped hiking rates.  

Historically, rate cuts have been the catalyst for equity markets to rebound, generally just before the end of recessions, but we do not expect a dovish pivot any time soon, unless something breaks, in which case, obviously, the market would not rebound. 

Until then, we do not exclude more bear market rallies similar to the four rallies we’ve seen so far this year. However, those rallies would be unlikely to be sustained unless we see a convincing turn in the macro. 

HP: Well, thank you, Dorothée , for your insights. We will carefully monitor the rest of the reporting season, not only of course for those headline numbers, but the all-important outlook statements coming through from management teams. 

Let’s move on to the week ahead, where the focus this week will be on the European Central Bank. Remember, euro area inflation accelerated in September, hitting a euro-era high of 10% year-on-year. Remember, that’s versus the target level of 2%. 

September’s reading is expected to represent the peak, however. Inflation should slowly moderate through the course of 2023, helped by government interventions in energy markets, and falling wholesale gas and electricity prices. 

Nevertheless, we continue to forecast that price pressures will remain elevated through the course of next year, with a harmonised index of consumer prices averaging 5.6% in 2023. 

In terms of the rates outlook, the European Central Bank’s Governing Council sent a very clear messages to the markets. They are, indeed, determined to tame inflation and normalise policy, despite the risk of recession. Policymakers delivered an unprecedented 75-basis point increase at the September meeting. We expect another three-quarter point increase on Thursday, pushing the deposit rate up to 1.5%. 

Given the high, persistent, and broad-based inflation, we anticipate the hiking cycle will be extended over the course of the next few months. For the December meeting, we forecast the European Central Bank will step down to a 50-basis point hike, however, followed by 25-basis point increases at both the February and March meetings. That puts the terminal rate at a higher-than-previously-forecast 2.5%. 

And with that, we’d like to thank you once again for joining us. I hope that you found this update interesting. We will, of course, be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.