To The Moon

Persistently elevated inflation have given central banks the impetus to raise rates in their quest to quell price pressures. To recap, the Feds introduced the first rate hike of 25bps in March and what followed was a series of more aggressive increases – May saw a 50 bps rate hike and later 75bps rate increases were imposed in June and July.

Since then, global markets have repriced substantially and US asset classes was no different. At a sectorial level, cyclical sectors sold off hard and so did the once high flying technology sector as the aggressive tightening path that the Feds embarked on have now sparked worries of a potential US recession – historically, a Fed hiking cycle has led to a recession occurring within a one to three year period. Hence, these concerns of a recession is not unwarranted for.

Chart 1: S&P 500 Index has suffered a rather brutal sell-off this year. Source: Bloomberg

Chart 2: US yields have risen substantially over the course of the year as the Feds hike rates. Source: Bloomberg

In fact, market participants’ fear of a recession have been proven somewhat right. At the current juncture, the US economy is experiencing a technical recession – a technical recession is when a country faces two consecutive quarters of decline in GDP. In essence, the largest economy in the world is not yet considered to be a recession as economists including those at the National Bureau of Economic Research defines recession to be a downturn that is deep, pervasive and long lasting. Nonetheless, there are still positives surrounding US equities despite market participants’ gloomy sentiments.

Chart 3: US GDP saw a decline in both 1Q22 and 2Q22. Source: Bloomberg

US firms reported better-than-expected earnings in spite of mounting recessionary risk

The US 2Q22 earnings season is almost drawing to a close at the time of this writing and has been positive thus far. In our view, this is an encouraging sight amidst the slew of negative news developments. Overall, almost 90% of firms have reported their earnings results for 2Q22. Of these firms, 74% of firms have reported positive EPS surprise as gleaned from chart 4 below. However, the percentage of firms which have recorded positive earnings surprises are still below their 5 year average of 77% and on a year over year basis, the S&P500 index is reporting its lowest earnings growth since 4Q20.

Chart 4: Majority of firms have displayed the ability to register earnings better than estimates during a period where growth is moderating. Source: Bloomberg

Chart 5: Magnitude of earnings surprise. Source: Bloomberg

Delving deeper under the hood, we note that the sectors that saw the highest proportion of firms reporting positive EPS surprise came from Real Estate (83.33%), Energy sector (81.82%) and Industrials (81.25%). The strong earnings coming from the real estate sector came as a surprise to us considering that the current macro conditions (higher mortgage rates and increasing home supply) should theoretically put downward pressure on the sector but instead, home prices have continued to surge which bolstered earnings.

Having mentioned that, in terms of earnings growth, the energy sector witnessed a whooping 95% of firms within the sector announce positive earnings growth, with an aggregate growth rate of over 300% – thanks in part to the years of underinvestment and the war in Ukraine, energy prices have soared due to the supply demand imbalance. Unsurprisingly, the sector also had a largest revenue growth amongst the 11 sector – sky high energy prices benefited energy companies.

Chart 6: The energy sector saw the largest number of firms reporting positive earnings growth. Source: Bloomberg

Chart 7: Firms in the S&P 500 Index registered a better aggregate earnings growth rate compared to the prior season. Source: Bloomberg

How did markets react to the robust earnings of US firms in 2Q22?

Generally, the market has rewarding positive earnings surprises and negative earnings more than average. According to FactSet, firms that reported positive earnings surprises for 2Q22 experience an average price increase of +2.9% two days before the earnings release through two days after the earnings release compared to the 5 years average price increase of +0.8% during the same time frame

On the flip side of the coin, companies that have reported negative earnings surprises for 2Q22 have seen an average price increase +1.2% two days before the earnings release through two days after the earnings which is well above the 5-years average of -2.4%.

Chart 8: Market price reaction to earnings. Source FactSet

In essence, market participants are placing more emphasis on fundamentals in today’s market terrain relative to the past year where growth potential outweighs fundamentals. Hence, the remarkable earnings results reported to date has spurred a rally in US equities in the month of July – all 3 index delivered positive returns with the NASDAQ index recording the largest gain followed by the S&P500 Index and Dow Jones index in SGD terms.

Chart 9: US equities saw the best performance till date in July. Source: Bloomberg

Can the earnings momentum sustain in the coming quarters?

Earnings of companies in the coming quarters will really depend on the Fed’s policy path ahead. The reason for our view is simple. If the Feds tightens too much during the coming meetings, the result could be a recession which markets fear. Yet, if the Feds tightens too little, inflation will be the greater threat – inflation is already eroding household savings and inventories of goods are elevated as demand begin to ease. Therefore, the ideal scenario will be for the Feds to achieve a proverbial ‘soft landing’.

Generally, we are not placing any odds on either scenarios but we do believe that inflation could perhaps be peaking as economic activity has already slowed substantially for two consecutive quarters. Having said that, we do not hold the view that the largest economy in the world will dip into a recession this year – retail sales have soften but the financial conditions of households remains healthy and should bolster spending, translating to continued support for economic growth, albeit subdued.

Chart 10: US household disposable income remains resilient. Source: Bloomberg

What we do expect is for earnings to come under some pressure as economic activities moderates and demand ease – our view is aligned with consensus forecast for earnings growth to fall off. Take for example the poster child of 2022, the energy sector. Prices of oil have pulled back from the highs seen earlier this year as market participants dwell over China’s zero-covid policy acting as a drag to demand. Basically, energy companies should see their revenue tail off and so will earnings.

Chart 11: Consensus have revised their estimates downwards for both 2022 and 2023. Source: Bloomberg

Is it the time to invest in US equities?

Valuations of US equities have come down significantly and earnings have been solid for 2Q – the S&P 500 index trades at a P/E of 20.25x, above its 20 year average, aligned with its 10 year average but below the 5 year average. In this vein, investors could perhaps be considering to include US equities into their portfolio.

No doubt, it is important to take a long term view when it comes to investing but we argue that is also wise to protect and position ones portfolio for the prevailing market place. We hold the opinion that there are investing opportunities within US equities and it pays to be selective. Our top pick for investors to alocate some of their monies into is the financial sector.

In a world where rates are on an upward trajectory, it spells positive for banks as higher rates can lead to higher net interest margins and therefore an expansion in profitability. Outside of banks, life insurance companies are also prime beneficiaries of higher rates – many life insurance policies involve guarantees and therefore a majority of the products are invested in treasury securities to avoid high risk or volatilities. (While life insurance companies hold a majority of their investments in low risk investments such as treasury securities, they are generally less sensitive to higher rates as they continuously reinvest dividends proceeds into higher yielding bonds.) Additionally, consumers will also have an added incentive to buy a life insurance contract because of the larger returns received, contributing to the earnings of these companies.

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