Markets Weekly podcast - 2 May 2023

Henk Potts (HP): Hello. It’s Tuesday, 2nd May 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, and 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 examine the earnings season. And, finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Positive earnings from the tech mega caps helped to offset concerns over the regional US banks’ mixed economic data and valuation challenges last week, though market participants were cautious ahead of this week’s crucial central bank meetings. 

In terms of market performance on Wall Street, the S&P 500 rose nine-tenths of 1% over the course of the week. The benchmark index was up 1.5% in April. In Europe, the STOXX 600 registered its first weekly loss in six-of-half of 1%, but still posted a monthly gain of 1.9%, its best since January.

In terms of bond markets, well, further evidence that US inflationary pressures are slowly easing encouraged traders to scale back peak rate bets. The 10-year Treasury yield closed the week at 3.4%.

Shares in US bank First Republic tumbled last week, as regulators sought to broker a deal for the struggling institution. Over the course of the weekend, it was announced that JPMorgan has agreed to acquire it, with the FDIC sharing some of the risk. 

We continued to get questions about whether we’re on the verge of a 2008 financial crisis rerun. We still believe that’s very unlikely. Authorities have done a good job of containing and isolating risk, including guaranteeing deposits, providing liquidity and orchestrating takeovers.

So, is this the financial crisis 2.0 playing out? Well, we should remember that capital levels are much, much higher today. Liquidity levels are significantly greater. Leverage within the system has been dramatically reduced, and the stress tests for the largest financial institutions are far more stringent compared to where we were back in 2008.

Now, that’s not to say that further pressure on the system will not occur in the coming weeks and months or years, but the risk of a failure of the financial system undermining the global economy, we think, has been dramatically reduced.

On the macro front, in the US, first-quarter GDP came in slower than expected and private consumption expenditures (PCE) inflation moderated. The US economy is estimated to grow at just 1.1% in Q1, significantly lower than that 2.6% in the fourth quarter, and below the consensus, which was at 1.9%.

Deceleration in growth was primarily driven by a reduction in inventory investment, although this was partially offset by an acceleration in private domestic final purchase. Actually, consumer spending surged 3.7% quarter-on-quarter.

If you look out to the second quarter, well, I think it’s going to be a challenging period for the US economy as rising savings rates, higher interest rates and the tailwind from excess savings start to fade. We expect US growth to slow to just half of 1% during the course of Q2.

The Fed’s preferred measure of inflation, the private consumption expenditures, PCE, rose one-tenth of 1% month-on-month, 4.2% year-on-year in March. Core rose three-tenths of 1%, coming in at 4.6% year-on-year, the core reading reflecting an easing of services inflation, including a much-needed deceleration in the housing component.

So, that was the global economy and financial markets last week. In order to discuss what we’ve learned so far from the earnings season, 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 quarterly reporting season is currently underway in the US and in Europe. How is the season developing so far, and are we seeing any trends emerge from those numbers?

Dorothée Deck (DD): Thanks, Henk. Good to be with you again. So, the past couple of weeks have been very busy in terms of reporting activity and, so far, 44% of the companies have reported in the US, and 37% in Europe. The key takeaway is that the first-quarter earnings have generally been better than feared, especially for the bellwether companies in the technology and industrial sector, as well as the systemically important banks.

However, it’s important to flag that the hurdle rate for companies to beat expectations was actually quite low, especially in the US. Earnings forecasts have been cut aggressively in recent weeks as concerns about financial stress and global growth have increased. So, more than 80% of companies have beaten expectations in the US and close to 70% in Europe, which is higher than average.

First-quarter earnings reported so far are flat year-on-year in the US and are 5% in Europe. This is 7% and 9% ahead of analysts’ expectations, respectively. Top-line growth remains positive in both regions, but it has slowed in recent quarters. And with regards to operating margins, they are down year-on-year in both regions, but the good news is that the margin erosion is generally lower than expected.

Now, if we look at the sectors driving the positive earnings surprise in the US, it has been led by consumer discretionary, materials, energy and industrials. And in Europe, it has been led by consumer discretionary again, utilities, industrials and financials.

HP: Dorothée, let’s get into some greater detail. What are investors focusing on this quarter? And, perhaps more importantly, what have we learned from management regarding the trading outlook for the rest of the year?

DD: So, the macro environment remains highly uncertain and growth expectations have come down in recent months. So, for investors the key areas of focus at present are 1) top-line growth and any signs of weaking demand, 2) pricing power as inflation remains elevated and operating margins are close to historical highs, and 3) the impact of tighter credit conditions, especially after the banking turmoil in March. 

Now, if we look at company guidance for the rest of the year, the tone is generally cautious. So, the proportion of companies issuing positive guidance in Europe is lower than it was in previous quarters, but, encouragingly, the proportion of companies guiding lower has remained relatively stable. 

Looking at company transcripts, European companies are generally less optimistic about the macro outlook. However, sentiment on inflation has improved. Inflationary pressures are generally seen as moderating, thanks to a decline in energy cost, supply-chain issues and raw material costs.

However, labour costs seem to have increased and remain a key concern for companies, especially in the tech sector as well as in financials and energy. Encouragingly, on the credit side, sentiment remains positive despite the recent stress in the banking sector.

HP: OK. Let’s try and put that in some sort of context for what it means for equity markets, which we know have been incredibly volatile over the course of recent weeks. What has been the share price reaction during the course of this reporting season?

DD: So, before the start of the reporting season, equity markets had rallied quite strongly from their March lows, as contagion fears from the banking crisis started to ease. Now, during the reporting season, it seems that share prices have reacted more to company guidance than reported-earnings surprises. 

So, basically, the companies beating consensus estimates have seen a muted reaction, their share prices performing essentially in line with the market on the day of the release. However, the companies missing expectations have been severely punished both in Europe and the US. Their share price has tended to underperform the market significantly.

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

DD: So, generally, our view is that earnings expectations are still too optimistic and likely to be downgraded in the coming months. This is true in the US, but also in Europe and globally. When you look at consensus forecasts today, global earnings are expected to be flat this year and up 11% next year. This doesn’t seem to reflect the current level of uncertainty, the recent deterioration in economic activity and the tightening in credit conditions. Historically, there has been a tight inverse relationship between credit conditions and corporate profits, with bank lending standards leading earnings growth by about six months.

At current levels, lending standards would be consistent with an 11% year-on-year decline in global earnings by September, which is pretty much in line with our top-down earnings estimate and previous periods of mild economic contraction. However, as mentioned previously, it compares with analysts’ projections of flat earnings for the full-year 2023, and this is why we expect more earnings downgrades as we get more information about companies’ trading outlook during the reporting season and as the year progresses.

HP: OK, Dorothée. So, how much of this uncertainty is already reflected in the price, and what are the implications for equity markets more generally?

DD: Well, the short answer to your question is that the equity market is not anticipating earnings downgrades either. At current levels, global equity prices are actually consistent with flat-to-slightly-positive earnings growth this year and a stabilisation of economic activity as opposed to a mild contraction.

This, obviously, implies downside risk to equity prices if corporate profits decline as we expect, but it should also translate into a high dispersion of returns within the equity market, as earnings prospects become more uncertain and as investors reallocate capital into higher-quality businesses. And, by dispersion of returns, I mean the spread between the best-performing stocks and the worst-performing ones.

To put this in perspective, the dispersion of returns today is very low in the context of the past 50 years. As the Fed has embarked on one of the most aggressive hiking cycles in history, stocks have become increasingly correlated with each other. They have been driven more by common micro factors than idiosyncratic risk, and in the past 25 years, higher levels of correlations have been observed only on three occasions, during the global financial crisis, the European sovereign debt crisis and the pandemic. 

So, to finish on a positive note, if we see an increase in dispersion or a decline in pairwise correlation in the coming months, this should open up more stock-picking opportunities for investors.

HP: Well, thank you, Dorothée, for your analysis today. You always do a great job, not only explaining the numbers but putting them into context for longer-term investors. So, as always, we appreciate your contributions.

Let’s move on to the week ahead where the focus this week will return back to the central banks with interest rate decisions from both the Federal Reserve and the European Central Bank.

So, for the FOMC, after instigating, as we were just hearing, the steepest tightening cycle since the 1980s, nine consecutive hikes, equating to 475 basis points since March 2022, we forecast the hiking cycle will be concluded with one more 25-basis point increase in May, after which we anticipate the US central bank will maintain the policy rate of 5% to 5.25% through the rest of this year.

Whilst 5% year-on-year inflation in March is still elevated, remember that’s still twice the targeted level, it has fallen from a peak of 9.1% in June 2022. Price pressures have decelerated for nine-straight months and are now back to their lowest levels since October 2021.

We think that’s a trend that will continue but we’ve got US CPI at 3.3% year-on-year in December, decelerating further through the course of 2024, to finish next year at 2.7%.

In terms of the labour markets, well, remember, US employment data remained very strong in March. In fact, the unemployment rate ticked down to 3.5% from 3.6%, which is still very close to the lowest levels that we’ve seen in five decades and the three-month average payroll gain remains robust at 345,000, led by gains in the service sector.

However, in the second half of the year, we would expect payroll growth to slow and then turn negative, and US unemployment to rise above 4%. In fact, we forecast US the unemployment rate will rise to around 4.4% at the end of this year. Therefore, expectations of moderating inflation, a cooling labour market and slowing growth should allow the FOMC to announce that policy is now sufficiently restrictive to return inflation back to its 2% target over time.

Therefore, we expect the committee to signal a pause for the June meeting, but with a hawkish tone, the committee indicating that additional policy firming could be implemented if required.

Markets, of course, are now debating the timing of the Fed pivot to an easing stance. We don’t envisage that happening until 2024. We currently project six quarter-point cuts during the course of next year, suggesting the target range for fed funds at the end of 2024 will be 3.5% to 3.75%.

In terms of the European Central Bank, we expect them to step down to a 25-basis point increase at this week’s meeting, reflecting elevated, but decelerating, inflation, mildly weaker-than-expected GDP growth. 

We expect the governing council to maintain its data-dependent approach, as the central bank assesses the impact of previous tightening and awaits the new economic forecast that’s due to be published in June.

However, the ECB is likely to indicate that further tightening will be necessary to bring inflation back to that 2% target over the course of the medium term. 

We forecast that the deposit rate will be at 3.75% in July, when we think the tightening cycle will end. We then expect the ECB to remain on hold till the second half of 2024, after which we expect it to cut policy rates cumulatively by 100 basis points over the following six months.

Now, the other big data release of the week will be on Friday, when we get the US employment report. We expect nonfarm payroll growth to slow in April to 200,000. We look for average earnings to increase by three-tenths of 1% month-on-month, 4.2% year-on-year. We look for the unemployment rate to hold steady at 3.5%, the participation rate to hold steady at 62.6%.

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

(end of recording)