Markets Weekly podcast – 17 July 2023

Henk Potts (HP): Hello. It’s Monday, 17th July 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 consider the prospects for the second-quarter earnings season. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Risk assets powered ahead last week on confirmation that price pressures in the US are easing, expectations that Chinese officials will provide additional stimulus to boost growth to shore up the housing market and hopes that companies can exceed undemanding second-quarter earnings predictions. 

Equity markets surged, bond yields tumbled, gold strengthened and the dollar weakened last week. The S&P 500 was up 2.4%, closing above the 4,500 level and near to its highest close since April 2022. Investors continued to buy growth stocks, technology outperformed. The Nasdaq, in fact, was up 3.3% last week.

In Europe, stocks posted their best weekly gain since March. The STOXX 600 was up 2.9%. Treasury yields declined for most of the week but did trim losses on Friday following the strong US consumer sentiment survey, the 10-year yields finished the week at 3.82%.

Foreign exchange markets: the dollar fell to a 15-month low as FX traders bet the Fed will shortly close out the steepest hiking cycle since the 1980s. Euro/dollar surged to 1.12, cable rose above 1.30 and the Swiss franc appreciated to its strongest level since 2015.

Easing bond yields and the lower dollar helped gold. The precious metal had its best week since April. It was up around about 2%, trading at $1,957 an ounce.

Moving on the macro side, well, US inflation moderated at a faster-than-expected rate in June. CPI fell to 3% year on year, compared to a peak, remember, of 9.1% in June 2022. Price pressures have decelerated for 12 consecutive months and are now back to their lowest level since March 2021, as base effects impact the year-on-year comparison, but, more fundamentally, both goods and services inflation has decelerated.

Core inflation also came in below expectations, at 4.8% year on year, helped by a decline in airfares, lodging away from home, and used-car prices.

Future progress, it has to be said, on bringing down inflation may be harder to come by due to less dramatic base effects, but we do see US CPI averaging 2.8% in the fourth quarter and just 2.2% in 2024.

Whilst the easing of the price pressures is likely to be welcomed by policymakers, we do not expect the print will dramatically alter the Fed’s view that further interest-rate hikes are necessary, given the ongoing labour market strength, remember, unemployment ticked down to 3.6% last month, the indications that we got from the June summary of economic projections and recent speeches from Fed officials.

So, we expect the FOMC to press ahead with that highly trailed 25-basis point rate hike at the July meeting. Beyond July, we still forecast a further quarter point, most likely in September, with the risk that the Committee views it appropriate to postpone that increase until the November meeting. We still see the terminal rate for this cycle being 5.5% to 5.75%.

Moving on to the UK, where labour market data finally showed some underlying weakening, but record pay growth will continue to unnerve the Bank of England. The UK unemployment rate ticked up to 4% in May. It’s actually still pretty low by historical standards, but pay growth remains very robust. Average hourly earnings, excluding bonuses, rose 7.3%. That’s the highest on record, but, adjusted for inflation, we should remember it’s still down 1.2%.

The supply of labour continues to be a real problem in the UK. Vacancies are still above that one-million mark, which is 25% above pre-pandemic levels. In terms of the outlook for the UK labour market, well, we think the unemployment rate will finish this year at 4%, and then steadily rise through the course of next year to finish 2024 at 4.5%. 

Now, the Monetary Policy Committee’s focus will probably move from labour markets to this week’s inflation report. You’ll remember that May’s inflation print came in at a stronger-than-expected 8.7% in the UK, the highest across the G7.

UK inflation has moderated at a slower pace than other regions due to its dependence on natural gas for power generation, the structure of government policies which were helping to shield the economy from higher energy bills, and the disruption that’s been caused to the supply of goods and labour due to Brexit. For June, we do expect CPI to ease, back to 8.1% year on year, driven by a fall in energy prices and a gradual moderation in terms of food prices.

We forecast that core will remain unchanged, at 7.1% year on year, as core goods inflation remains stable, only seeing a mild easing of price pressures in services.

Looking out, well, we anticipate that price pressures will remain elevated. We’ve got UK CPI averaging 7.2% this year. We still think it will be printing around 4% in December, and further forecast headline inflation will remain above the target level through the course of 2024, in fact, finishing next year still at 3%.

In terms of its impact on rates, you’ll remember the Monetary Policy Committee hiked by a larger-than-expected 50 basis points in June. We think they’ll go for another half-point increase in August, followed by 25 basis points in September. We hope that will be enough, with a terminal rate for the bank rate being 5.75%. We know, of course, that there are risks and they are skewed to the upside, with markets still pricing in a terminal rate around 6%.

So, that was the global economy and financial markets last week. In order to discuss the expectations for the second-quarter earnings season and the implications for investors, I’m pleased to be joined by Dorothée Deck, Cross Asset Class Strategist with Barclays Private Bank.

Dorothée, great to have you with us today. The second-quarter earnings season has just started, with the large US banks reporting on Friday. What are the expectations for the US and for European earnings during the course of this quarter, and which sectors are expected to form the best and, on the opposite side, which areas are we really worried about?

Dorothée Deck (DD): Hi, Henk, good to be with you. So, yes, only a small number of companies have reported so far, but the vast majority are expected to report over the next three weeks. So, by the end of July, two-thirds of the companies will have reported in the US and Europe, if you look at it by market cap.

We have seen significant earnings downgrades in both regions in recent months and I guess it’s fair to say that expectations for the second quarter are not demanding. So, the hurdle rate for companies to meet expectations is quite low. 

Second-quarter earnings are now expected to decline by 8% year on year in the US and by 13% in Europe, and that would make it the biggest earnings decline since the fourth quarter of 2020. Analysts expect margins to contract in both regions and revenues to decline in Europe but remain broadly flat in the US.

Now, as a common theme across the US and Europe, banks and insurance companies should be one of the largest positive contributors to earnings growth at the index level, while energy and materials should be the biggest drag by far. And to give you some numbers, financials are expected to contribute 2% of earnings growth at the index level in the US and as much as 9% in Europe.

With regards to energy, the sector is expected to reduce earnings growth by 6% in the US and by 7% in Europe. Now, if we look at the sectors individually, the biggest earnings declines in both regions are expected to come from energy and materials, with year-on-year declines ranging between 30% and 60%. And, in contrast, double-digit growth in earnings is expected from consumer discretionary in the US and financials and tech in Europe.

HP: Dorothée, what would be the key areas to watch in those earnings releases?

DD: So, we expect the market to focus on four key areas this quarter: 

Number one, pricing power, or the ability of companies to protect margin as the economy slows down and inflation moderates. So far, margins have remained resilient across sectors, but any signs of pressure will be closely watched.

Number two, the impact of higher rates and tighter lending standards on consumer demand and corporate investment, but also on refinancing costs and credit quality in general.

Number three, comments around the long-term impact of artificial intelligence on business models and future profits.

And, number four, as always, company guidance on trading outlooks for the remainder of the year. Now, on that point, it is worth flagging the divergence in the activity surprise seen at the regional level in recent months. While economic activity has been more resilient than expected in the US in the past three months, it has rolled over sharply in Europe and China, with data coming in significantly below expectations. So, we could see some earnings disappointments in Europe this quarter or downward revisions in earnings guidance.

Now, guidance from the banks and technology companies will be particularly important this quarter for different reasons. Sentiment on the banking sector has been very weak, following the collapse of Silicon Valley Bank in March in the US. The aggressive tightening in bank lending standards has already translated into a significant slowdown in loan growth. But investors will also want to know how this tightening is impacting their deposit base, funding cost and credit policy. Any comments on the expected impact of tighter regulation on the future profitability of this sector will also be keenly watched.

With regards to the tech sector at large, it has very much driven the equity rally in the past three months on expectations that artificial intelligence will have a profound impact on the economy. Given the extent of the moves and how difficult it is to assess the long-term impact of AI, guidance in that space will be closely watched. 

So, investors will try to understand the opportunities and risks associated with AI, the time it might take for AI to impact future profits and, more importantly, they will try to differentiate between the most likely winners and losers of the new technology. Any comments on potential export restrictions on AI chips to China and any other country will also be important.

HP: So, you mentioned earlier that earnings expectations have been revised down in recent months. What is your view on consensus forecast today? Are they more realistic, or do they need to be adjusted further?

DD: So, analysts are now expecting global earnings to be flat in 2023 and rebound by 11% in 2024. We believe this is too optimistic given the current macro environment. The manufacturing sector is in contraction territory, credit conditions have tightened aggressively and the full impact of higher rates on the economy remains to be felt. This type of environment would normally be consistent with negative earnings growth.

If you look at US bank lending standards, they tend to lead global earnings growth by approximately six months. At current levels this suggests that global earnings could actually decline by about 10% this year, and we get to a similar conclusion when we look at the historical relationship between earnings and economic activity, as shown by the ISM Manufacturing Index.

HP: Well, after a strong rally over the course of the past few months, equity markets appear to be discounting a soft-landing scenario very much at odds, actually, with the current economist forecast. How much of a disconnect do you see between equity valuation and the current macro picture, and what does that imply for investors?

DD: So, global equities have now rallied by 26% from their October lows and stand only 8% below their all-time high. Price-to-earnings multiples have normalised and are now back above their 10-year average, and this looks stretched to us considering the weak macro backdrop. At current levels, global equities are pricing in a significant rebound in economic activity and corporate earnings. 

On our numbers, they’re discounting an ISM Manufacturing Index of approximately 56, significantly above the 46-level reported in June. This implies that the manufacturing sector moves back into expansion territory, and it would be consistent with GDP growth above average. That’s not our base case scenario. Our economists expect global GDP growth to slow to 2.7% this year and 2.3% next year, below trend growth of 3.3%.

Similarly, global equities are discounting stronger earnings growth of about 14% this year versus consensus expectations of flat earnings and our own expectation of a decline, as I mentioned earlier. So, unless we see a material improvement in the macro environment and a strong rebound in corporate profits, equity markets are at risk of a pullback in the near term, and this disconnect between the macroenvironment and markets calls for increased prudence, selectivity and downside hedges.

HP: Well, thank you, Dorothée, for your insights today. It was certainly interesting to have the current earnings expectations put in some context but also for your thoughts on the ramifications for equity markets.

Let’s move on to the week ahead where the focus beyond the UK inflation report will be the latest US retail sales and industrial production figures, where we expect that US consumer spending will have remained resilient during the course of June. Indicators, including credit-card transactions, point to a solid half of 1% month-on-month increase in retail sales, on the heels of May’s 0.3% gain.

This trend looks to be broad based, with the car category continuing to be lifted by June’s increase in light-vehicle sales. In contrast, industrial production indicators point to another lacklustre month in the industrial sector, with overall production posting a second consecutive 0.2% month-on-month decline.

We expect mild declines across all major groups in June, including a one-tenth of 1% month-on-month fall in manufacturing activity, with assembly schedules showing that car production cooled a touch from post-lockdown highs that we saw in April and in May.

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