Two things determine the level of the stock market. The profits companies are making, and the price investors are prepared to pay for them. Last year’s stock market slide was all about the valuation side of the equation. Earnings were surprisingly resilient. But as the first quarter results season approaches in the US, there’s mounting speculation that the earnings shoe is preparing to drop.
As usual, it’s the big US banks which get things going this week, as they unveil their profits for the January to March reporting period. It’s fitting that the banks should be first out of the blocks because a big theme of this earnings round is certain to be the impact of last month’s turmoil in the financial sector. What the banks have to say has a broader significance because the stresses and strains on their balance sheets have the potential to ripple out into the wider economy via tighter lending standards, a kind of mini credit crunch.
That was the thrust of the International Monetary Fund (IMF) gloomy half-yearly assessment of the health of the global economy this week. The IMF warned in its World Economic Outlook that a vicious cycle of high inflation, rising interest rates and financial fragility is likely to lead to sharply lower global growth than it had anticipated even just three months ago.
After growing by 3.4pc in 2022 the global economy is expected to expand by just 2.8pc this year. The developed world is likely to be even harder hit, with economic output in the richest countries rising by as little as 1pc, depending on the extent to which lending dries up. Britain was singled out as the biggest loser among the developed countries, with a 0.3pc decline in output pencilled in for the current year. Only Germany is also going backwards.
That’s a problem for Jeremy Hunt, the Chancellor, because it means that the UK is now very unlikely to meet two of the government’s fiscal rules. Debts are unlikely to be falling in five years’ time at the end of the forecasting horizon and they probably won’t be less than 3pc of GDP at that point either.
This is the tricky backdrop to what is certain to be the most difficult earnings season since the early days of the pandemic. According to data provider Factset, earnings for the biggest US companies are due to fall by more than 6pc this quarter. That will be the worst performance since the plunge in profits as the world shut down in early 2020.
This will come as no surprise to the many investors who have been scratching their heads as to why the stock market has held up so well in the first few months of 2023 at the same time as the odds have shortened dramatically on a global recession at some point in the next year. The stock market is usually a prescient forecasting machine, which suggests that either investors or economists have got it wrong. The next few weeks are likely to tell us which it is.
Less important than the numbers presented by the banks will be what they have to say about the availability of credit in the months ahead. With depositors heading for the exits at many smaller banks, preferring the increasingly attractive yields on offer by money market funds, banks may be less able, or less inclined, to lend to businesses and households. As credit dries up, the potential growth in the economy will slow and that will inevitably feed through into corporate earnings.
The second sector in focus in the weeks ahead will be technology, for a slightly different reason. The big tech stocks are less dependent on funding from the banks because they are giant cash-generating machines and so more self-reliant. However, their value is directly impacted by the level of interest rates because these determine the present-day value of their prodigious future profit streams. Lower interest rates make these cashflows more valuable today and vice versa.
One of the reasons that stock markets have held up in the face of growing recession fears is the expectation that slowing growth will lead in due course to lower interest rates and so higher valuations for tech stocks. Such is their importance to the overall value of the stock market that the recent rally in this sector has disguised a much less exciting performance by the rest of the market. The resilience of the S&P500 is largely a consequence of the rising prices of just a handful of companies.
To really understand the message from the earnings announcements over the next few weeks, it will be necessary to look behind what is expected to be a wide dispersion in results. According to Factset, the service side of the economy - restaurants, hotels, airlines and the like - is likely to be in rude health compared with a year ago. At the other end of the spectrum, expect materials and industrials companies to feel the pinch as manufacturing battens down the hatches ahead of the expected downturn.
If earnings do fall during the upcoming results season attention will refocus on the valuation side of the market puzzle. Despite last year’s reset, these remain elevated in the US relative to the rest of the world. A high single digit decline in profits is not consistent with shares trading on 18 times expected earnings, so falling earnings could be just half the story. Investors are bracing themselves for a double whammy of poor results leading to weaker sentiment too.
And why should we care? Well, as they say, when Wall Street sneezes the rest of the world catches a cold.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
