By Dr. JoAnne Feeney, Portfolio Manager
The headlines of late have indeed been worrisome, whether it be high inflation, rising interest rates, China’s zero-Covid policy, or war in Europe. (But that is the nature of headlines.) Market risks remain above normal. Elevated risk and higher interest rates tend to lower stock valuations, while higher future earnings raise valuations. We have seen many stocks decline because of the former, but we are now entering a period where earnings fundamentals have the chance to dominate the narrative as companies report first quarter results and provide guidance for 2Q and the full year. Should we expect good news and how much should it matter?
When companies reported their 2021 results earlier this year and provided guidance, many turned cautious and more companies cut guidance than not. Omicron was causing a spike in Covid cases, and consumers were pulling back on activities. Companies noted elevated risks and pointed to ongoing supply chain issues, but they also remarked that Omicron would be short-lived, the supply chain was starting to improve, and the second half of the year should be better. Investors remained skeptical.
Now, three months on, companies have seen Omicron fade, but other disruptions have come to the fore. Russia’s invasion triggered sanctions, reduced exports of metals and grains from that region, and worsened the global shortage in the supply of oil. China’s zero-covid policy once again disrupted the production of consumer electronics and cars and slowed the flow of products in and out of Chinese ports. Statements by Federal Reserve officials imply that several rate hikes lie ahead. And CPI inflation hit a hew high.
Understandably, we shouldn’t expect much optimism from companies regarding sales and earnings for this quarter, but the state of the US economy suggests we may very well hear indications of improving growth prospects for the second half of the year. As our Chief Investment Officer, Chuck Lieberman, wrote a couple of weeks ago, it is premature to anticipate recession, regardless of headlines to the contrary, because the US is unambiguously still in expansion territory (and has a long way to go). Now that earnings season is upon us, we will hear from companies as to the conditions they are seeing on the ground. More importantly, we will get clues on their positioning for the rest of this year and whether they are likely to be able to power through these macro risks.
Last week may have started out with those high inflation numbers, but it finished with a very strong read on US manufacturing. Friday’s Industrial Production report came in better than expected with output up 0.9% month over month versus an expected 0.6%. This strength was driven by greater production of autos (as shown in lower half of chart) and business equipment. Moreover, capacity utilization is up to 78.7% from 78.1% in February; it is the highest it’s been since 2007 (but has room to increase further). Firms are having some success filling job openings. This matters because more workers enable factories to run hotter and provide households with more income to boost spending. This creates a positive backdrop as we are likely to hear from companies over the next several weeks.
So, while the recent narrative has been all about the macro negatives—especially high inflation and rising rates— now it’s earnings chance to dominate the news, as companies begin reporting first quarter results and provide guidance for 2022. While risks and rates can only go so high, earnings can keep going higher year after year after year. This is the critical force behind the attraction of long-term investing that has powered the S&P 500 up over 1,000% over the last 30 years. While we should be prepared to hear continued near-term caution, we need to focus more closely on the clues companies provide on plans that will drive the longer-term trajectory of their sales and earnings. And because we are in a period of elevated risk, while we position portfolios to take advantage of both cyclical and secular growth, we are also building in holdings that will do well even as inflation, rates, and geopolitical tensions remain high.
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