As colder weather descends across the northern hemisphere, some intrepid souls are bound to lace up their boots, grab their ice-fishing gear, and head out to the frozen lakes and ponds. But proceed carefully, for we live in an age of climate change. Beware of treading out too soon or too firmly. Best to tiptoe onto the ice.
The same can be said for investors—caution is becoming the headline for the capital markets in 2022. Fortunes began to shift with fading fiscal stimulus hopes last autumn. A bigger jolt arrived with clear signs that central bankers were jettisoning their patience with inflation and preparing to tighten.
But equity investors could take comfort that robust corporate earnings would support higher market valuations. Despite unfavorable conditions, pond fishing for equities offered a good haul for those willing to venture out onto the ice.
Indeed, according to consensus analyst forecasts, as captured by FactSet, corporate profits in the past Q4 earnings season will increase by nearly 22% compared to this time a year ago. Sounds good, eh? Best to enjoy it while it lasts—the policy winter looks to be longer than that of the fishing season.
The reason is simple.
Strong year-on-year earnings growth will fade as favorable base effects disappear. Put simply, today’s earnings growth rates are boosted by comparisons to the trough in profits gouged out in 2020 by Covid and damaging economic lockdowns. By the middle of this year, easy comparisons will likely be a thing of the past. Earnings growth will slow to the rate of nominal GDP growth—below 10%.
It might get worse. Labor, capital expenditure, and debt servicing costs are all slated to rise this year. A few dominant firms, who exercise extreme market power, may be able to fully pass along higher costs to their customers via higher prices. But they will be the exception. Most will not.
Recall, after all, that US consumers have already drawn down substantially on savings piled up during the lockdowns. Government support programs such as extended unemployment benefits, direct grants, and child credits are drying up. Eviction moratoriums are expiring for renters, who nervously face costly moves or rent hikes. Meanwhile, home heating and gasoline (petrol) prices are soaring. Food prices have jumped. Price increases are becoming more widespread.
Consumers, in other words, may resist higher prices. A single data point is never decisive, but last week’s disappointing December retail sales report could signal consumers are already balking. It is notable that the poor numbers cannot be blamed on omicron-related reluctance to visit the malls as the steepest decline in the report was online sales.
Meanwhile, the US economy is approaching full employment. Economists may reasonably debate whether disgruntled workers will now return to their former jobs, but for investors, the arrival of full employment typically coincides with the arrival of peak profit margins. From here, margins will come under pressure as costs rise faster than revenues. This is important.
A first hint arrived on Friday, courtesy of the earnings reports from JP Morgan and Citigroup, where higher wages, salaries and bonuses caught investors by surprise. But this is not just about six- or seven-figure compensation packages for the privileged few. Last year, the bottom 25% of American workers enjoyed the fastest wage gains, particularly as more states and companies pushed minimum wages toward $15 per hour. Strong hiring alongside a wage bump for new and existing workers will increase costs for sectors such as retail and food services, travel and transportation, among others. Few firms will be immune, as labor costs represent about two thirds of all expenses for the average listed US company.
Investors have taken note. The prospects for slower economic growth given a fading fiscal impulse, tighter monetary conditions, and moderating household demand are reflected in the lagging share price performance of traditional cyclical sectors such as industrials or basic materials. Other cyclicals, such as financials or energy, have done better, but that is largely down to unique favorable factors, such as robust capital markets and higher interest rates for financials or supply impediments that have boosted oil and natural gas prices. Overall, investor appetite for cyclicals has receded.
Yet investors remain committed to equities. They prefer rotation within the market to rotation out of it. Thus far, that makes sense. Gold and cryptocurrencies have failed in their promise to hedge rising inflation. Cash is seen as a wasting asset. And given the threat of rising interest rates, bonds remain unattractive. Bonds will only return to favor when yields have peaked, which few believe is yet the case.
In short, fiscal, monetary, and earnings supports for equities are waning in successive fashion. Before long, the case for holding equities may largely rest on investors’ conditioning that there is not anything better to do with their money. While this has been true for a long time—arguably since the great financial crisis—rising interest rates driving returns in the fixed income market juxtaposed against weakening corporate earnings may finally undermine the faith that equities are the only place to be. It ought to concern us that a generation of younger investors has only known a ‘reality’ where equities go up and interest rates hover around zero.
In truth, the ice is shifting beneath the feet of investors. Cracks are emerging. Fishing on the pond is becoming more suspect. Tiptoe carefully.
