2Q 2022 International Equity Outlook: Volatility may amplify risks to earnings growth

Volatility may amplify risks to earnings growth

Volatility ensued in the first quarter with global inflation rising to record levels (particularly in developed markets), a spike in interest rates, the Russian invasion of Ukraine, supply chain bottlenecks, and COVID-induced lockdowns in China. These combined to put downward pressure on markets and upward pressure on oil and commodity prices. Earnings are at risk given the volatile environment yet sell-side earnings estimates for 2022 and 2023 are fairly stable, which indicates that current valuation multiples are unreliable.

Resilience is key

If the economy deteriorates, which is plausible, and earnings prove to be worse than expected, investment performance will come from companies with resilient earnings growth. Quality companies with high margins can absorb cost increases and inflation. The energy sector may continue to outperform as the oil price continues to rise. However, higher energy prices increase the risk of a recession.

The Russia invasion exacerbated risks that were already in place, accelerating energy prices and tightening supply chains. Economic conflict with Russia negatively impacted the European Union, with the largest European banks starting to provision for credit losses. Disruption to the supply of fertilizers and wheat from Russia and Ukraine put pressure on food prices. We will closely watch labor negotiations in Los Angeles and Long Beach ports this summer, which could result in further disruptions to supply chains.

Quality businesses can ride out the storm

We believe some lower quality businesses may start to suffer, such as a European bank with exposure to Russia, a global home appliance manufacturer that was hit by a perfect storm of weakening demand in Europe, price increases in raw materials and supply chain shortages, and a German chemical manufacturer provided a cautious outlook because of the shortages in the supply of gas.

Other recent views

In a recent article, “ The Road is Long – Navigating Through Inflation and Uncertainty ”, Client Portfolio Manager Ben Falcone explains that central banks were behind the curve and are now forced to tighten amid weaker equity markets and a flattening yield curve. There have not been prolonged inflationary periods for quite some time, especially in developed markets. Data from the US in the 1970s points to quality businesses outperforming significantly. Less volatile businesses with greater profit persistence -- large brands or extensive IP intensity, or consumer and IT focused areas – tend to survive inflationary periods better than energy, financials, and materials.

The US is home to some of the most well-known companies in the world, but most of them are multinationals, like Apple, Google (Alphabet), and Mastercard, that provide exposure outside the US. In an article Accessing Quality American Businesses You Won’t Find in the S&P 500 , portfolio manager Donny Kranson explains that many of the brands that US consumers think are domestic are actually owned by foreign companies, like Tiffany jewelry, Gerber baby food, and Milwaukee power tools.

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