Where do fixed income investors go from here?
Second quarter earnings season has begun in earnest with market participants eagerly awaiting Q2 results to shed light on just how well corporate America is fairing. Heightened inflationary pressures have potentially affected corporate bottom lines with lower revenues, compressed margins and higher labour costs all likely to have played a role in Q2 results and also likely to affect forward guidance as we steer towards an economy that is showing signs of slowing down.
Thus far, with just over 20% of the companies in the S&P 500 having reported, 65% of these companies have reported actual revenues which have beaten estimates. Given the current economic environment, on the face of it, this sounds like a good result given they are only slightly below the five-year average of 69%. In aggregate, companies are reporting revenues 1.35% above estimates, which is also slightly below the five-year average of 1.8% according to data provided by FactSet.
Earnings season started off well with the major US banks generally reporting healthy earnings on the back of continuing solid consumer spending growth, steady loan growth and improving net interest margins as a result of rates moving higher (read our previous blog: US bank chiefs still like the consumer ). However, there have naturally been some warning signs as well with a few bellwethers such as AT&T and Verizon grabbing headlines last week. AT&T warned that more of their customers are starting to fall behind on their bills while Verizon also added to concerns noting that higher prices were affecting subscriber growth.
Another important indicator we will be monitoring alongside earnings releases are plans for any reduction in corporate hiring. For instance, Ford recently announced plans to cut 8,000 salaried positions at its internal combustion division in order to use those funds to further invest in its EV push. Google has paused hiring to allow the company to review headcount needs and align on a new set of staffing requests for the next three months. Apple has plans to slow down hiring and spending growth in 2023. Microsoft is another company expressing concerns with plans to hit the brakes on hiring. Earlier this year, even Tesla announced plans to reduce their salaried workforce by 10 percent. The list goes on. Overall, the market has reacted quite positively to the earnings posted thus far with the ICE US High Yield Index improving 30 bps over the past week. Nonetheless, we have a busy week ahead of us with the big tech companies such as Microsoft, Alphabet, Meta, Apple and Amazon slated to report and where we expect more details on hiring to be addressed. On top of that we have the FED meeting (with markets anticipating a 75 bp rate hike), Q2 GDP numbers and finally the PCE deflator (which is the Feds favourite inflation monitor).
The devil is in the detail and this earning season we will be looking to forward guidance as well as focusing on recent earnings. Should the upcoming earnings season and outlook provide confirmation that the economy is still showing signs of strength and healthy earnings, Fed policy may still be on track towards reaching their expected Fed Funds target of 3.375% by the end of 2022. However, should it be seen that earnings are underwhelming with labour pressures subsiding & unemployment levels increasing (as companies find the need to slow down their hiring requirements), this would tick one of the Fed’s boxes towards their desired outcome of slowing the economy. The latter scenario would provide some ammunition that Fed policy would require a slower pace of rate hikes should it have the desired effect on inflation. In fact, last week’s economic data did provide some further signals that Fed policy is having the desired effect; initial jobless claims were higher than they have been for some time, US PMIs continued to contract, and the Philly Fed Business outlook declined substantially.
In conclusion, whereas the Fed tolerated higher inflation earlier this year in support of a strong labour market, and appearing to fall behind the curve in the process, they now appear to need to tolerate higher unemployment in the fight to lower inflation. To this end, the current earnings season should help set the landscape and hopefully give us an insight as to next quarter’s corporate health as well as what the rest of the year could look like. Should we continue to see signs of economic contraction, we would expect the Fed Funds rate to settle at levels below their current forecasts, and in so doing , reduce some of the volatility found in rates markets currently. On the other hand, should we continue to see consumer resilience flow through positively to corporate earnings , we would expect this to be seen as a contributing factor to keeping Fed policy on its current track.