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After a torrid first half of the year for the U.S and global stock market investors, we entered July with warnings from many market commentators that more bad news was on its way. This time from corporate earnings.
Valuations had fallen over the previous six months, the argument went, because of the upcoming hit to corporate earnings as inflation, higher interest rates, and weak economic growth took their toll.
Furthermore, these macroeconomic factors coincided with a downturn in the global inventory cycle as many good companies battle with excess inventory after having over-ordered during the pandemic.
And yet…the second quarter earnings results have shown resilience in most sectors, with a good number of companies in European exchanges and on the S&P500 beating expectations, though not as many as in a previous couple of quarters.
Importantly, outlook statements have expressed caution, not doom. High employment levels and large household and business cash balances are expected to help maintain demand even as uncertainty over future economic conditions mounts.
Certainly, there have been negative surprises: the microchip sector faces a global oversupply as high inventory levels amongst customers are worked through (bad news, for example, for Intel). And non-profit growth companies in areas such as tech and biotech are struggling to raise capital to meet their product development targets.
Yet U.S mega-tech, that is highly cash generative (and some would say is largely ex-growth), delivered a generally solid set of results with positive earnings outlooks (e.g., Apple, Amazon and Microsoft).
Meta disappointed, reporting its first fall in revenue ever, and reducing the outlook for revenue growth in the current quarter. Tech companies disproportionately reliant on advertising revenue attracted most analyst scrutiny.
Despite rapid growth in net interest income (NII), as interest rates rise, U.S and European banks are bracing themselves for a wave of loan defaults. In addition, banks may suffer a wave of vengeful taxes and levies on profits from European governments (note Spain and France).
Meanwhile, merger and acquisition activity is drying up as the cost of finance has risen, and risk aversion has crept into the corporate and investor mindset (as noted in the results from JP Morgan and Morgan Stanley).
Thankfully, the western global banking sector has plenty of capital. Bank analysts’ biggest fears are focused on China, where there are growing defaults on mortgages.
Meanwhile, demand has held up in many sectors that one would have considered highly cyclical and vulnerable to weakening economic sentiment. Take travel and leisure, where American Airlines recorded record profits, and Hilton Worldwide reported continued strength in post-pandemic travel demand.
Energy companies are recording very strong profits, earning them the wrath of consumers and politicians. The anger they face is aggravated by increasing evidence of an industry-wide cover-up by Big Oil, of climate change knowledge that goes back to the mid-1990s. On 11 July, the U.K parliament approved a new energy windfall tax. We can expect other countries to follow suit.
Consumer staples, such as Unilever, Nestle, Coca-Cola and McDonalds all reported confidence in passing on rising input prices to their clients.
So how will we see the much-anticipated economic downturn affect corporate earnings?
Higher borrowing costs will reduce employment growth in the U.S and Europe. As job insecurity becomes a problem, household energy costs mount over the winter months, and savings are drawn down, we can expect to see discretionary business and consumer spending damaged. Whether it be auto sales, travel and leisure, or advertising and other peripheral service sectors not considered vital for a business’s survival.
Meanwhile, the energy and mining sectors, utilities, financials, and consumer staples appear to be best placed to weather the storm. The large U.S. cash-generative tech companies may see sharply divided fortunes, depending on their reliance on advertising revenue.
Investors should remain diversified by geography and sector.
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