To The Moon

Elevated inflationary readings and the Fed’s rate hiking cycle have placed US equities under immense pressure this year. To recap, the Feds introduced the first rate hike of 25bps in March and later imposed a series of more aggressive increases – May saw a 50 bps rate hike, and later 75bps rate increases were imposed in June, July, September, and November.

What followed was US equities repricing substantially. Cyclical sectors sold off hard and even so the likes of the technology sector. That being said, the main motivation behind the rout witnessed, in our view, is the fear that a full-blown recession would occur in the world’s largest economy as jumbo-sized rate hikes became a norm – historically, a Fed hiking cycle has led to a recession occurring within a one-to-three-year period. Therefore, the fears of market participants are not unwarranted.

Chart 1: US market performance YTD has been poor. Source: Bloomberg

Market participants’ fear of a recession has been proven somewhat right. The US economy has experienced a technical recession in the first half of the year – a technical recession is when a country faces two consecutive quarters of decline in GDP. However, just as many expected another quarter of decline in GDP in the world’s largest economy, an encouraging result was reported – 3Q22 saw the US economy register a pick-up in growth. This leads us to the question: ‘how are companies faring as the US economy avoids a decline in growth?’ In the following sections, we will look at what could be taken away from the earnings reported by companies in the S&P500 Index in 3Q and discuss our views going ahead.

Chart 2: US GDP managed to avoid a decline in 3Q. Source: Bloomberg

Earnings of firms in the US have tailed off compared to 2Q22

The US 3Q22 earnings season is drawing to a close at the time of this writing and has thus far been resilient but weaker than the season prior. Overall, 92% of the companies in the S&P500 have reported earnings to date for the third quarter. Of these firms, 69.96% have reported positive EPS surprises as gleaned from chart 3 below. Nonetheless, the percentage of firms that have recorded positive earnings surprises is still below their 5-year average of 77% and below the 10-year average of 73%.

Chart 3: The percentage of firms that have beaten earnings estimates has fallen compared to the season prior. Source: Bloomberg

Chart 4: Magnitude of earnings surprise. Source: Bloomberg

Delving deeper under the hood, we note that the sector that saw the highest proportion of firms reporting EPS surprise came from the industrials (79.69%), consumer staples (76.92%), and the energy sector (76%). Comparing the current data to a season prior, investors would notice that the real estate sector has fallen out of the top 3 sectors which saw the highest proportion of firms reporting positive EPS – higher mortgage rates and increasing home supply have applied downward pressure on the sector.

Chart 5: Industrial sector saw the largest number of firms reporting earnings growth. Source: Bloomberg

In terms of earnings growth, the energy sector as a whole reported the highest year-over-year earnings growth of all eleven sectors at 149.22%. Such remarkable earnings growth was thanks to the high energy prices due to years of underinvestment and the military conflict in Ukraine creating an imbalance in the supply-demand equation – despite an economic slowdown, energy prices remained high as compared to a year ago with the average price of WTI oil in 3Q22 sitting at $91.62 compared to the average price of $70.56 in 3Q21.

Chart 6: Aggregate earnings growth of firms in the Index has fallen compared to 2Q. Source: Bloomberg

Chart 7: Oil price may have pulled back from the highs earlier this year but remains elevated. Source: Bloomberg

How did markets react to the earnings result of US firms in 3Q22?

Generally, the market has rewarded positive earnings surprises and punished negative earnings surprises more than average. According to FactSet, firms that reported earnings surprises for 3Q have seen an average price increase of 2.4% two days before the earnings release through two days after the earnings release compared to the 5 years average price increase of 0.9% during the same time frame.

On the flip side of the coin, companies that have reported negative earnings surprises for 3Q22 saw an average price decrease of -3.5% two days before the earnings release through two days after the earnings release, a percentage significantly larger than the average price decrease of -2.2%. In essence, market participants have continued to emphasize fundamentals in today’s market terrain relative to the past year where growth potential outweighs fundamentals.

Chart 8: Market price reaction to earnings. Source: FactSet

Can the earnings momentum sustain in the coming quarters?

Earnings coming in better than expected this season can be attributed to companies having the ability to pass on higher costs. In this vein, we would like to highlight that companies within the S&P500 Index are still reporting the lowest share of profit beats since the first quarter of 2020 even after expectations were lowered going into the season. That said, we believe that the worse is yet to come. With growth slowing, higher costs, and staffing headaches (on one hand, Big Tech companies are laying off workers and on the other, wages have become a pain point as Americans contend with soaring costs) we hold the view that earnings in the coming quarter will continue to tail off.

Chart 9: Earnings have been revised downwards. Source: Bloomberg

Is it time to invest in US equities?

Valuations of US equities have come down significantly. The S&P500 Index trades at a forward 12m P/E of 18x, below its 10 and 5 years average of 18.3x and 19.8x respectively. Given earnings downgrades by analysts and valuations still appear attractive, investors could perhaps be considering allocating some of their monies into US equities. On this note, we would like to emphasize that it is important to take a long term when it comes to investing but we argue it is also wise to protect and position one’s portfolio for the prevailing marketplace. We hold the opinion that there are investing opportunities within US equities but it pays to be selective. Our top pick for investors to allocate some of their money into is the financial sector.

Chart 10: S&P500 valuations appear attractive. Source: Bloomberg

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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