Stock Bulls Need a Strong Earnings Season. It’s a Tough Ask

A positive earnings season could provide a lifeline to a stock market rattled by ever-rising bond yields and mixed economic data.

(Bloomberg) — A positive earnings season could provide a lifeline to a stock market rattled by ever-rising bond yields and mixed economic data.

The bad news is that the prospects of such a rescue appear dim. 

There’s a long list of headwinds for equities: the unresolved debate over whether the economy will experience a hard or soft landing, volatility in bonds that’s discouraging risk appetite, a strengthening dollar and geopolitical uncertainties. Barclays Plc strategists say this is stacked against very few positives, such as seasonality and a low bar for companies to clear in their third-quarter reports.

“The pullback has purged complacency and finally aligned equities with higher-for-longer rates expectations,” said the Barclays team led by Emmanuel Cau. They regard the quality of the next batch of corporate profits as “holding the key” to equity performance. 

An encouraging set of results may trigger a “modest year-end rally,” according to Cau’s team. But “any signs of weakness would provide fodder for the perfect storm,” an outcome that seems closer to current investor positioning and sentiment, they said. 

Stocks could be subject to further volatility spikes — such as the one recorded in the Cboe Volatility Index in recent days — until markets see signs that bond yields are really peaking, which may not happen until the Federal Reserve’s next meeting in November. In the meantime, investor attention will turn to earnings, with the season kicking off next week in the U.S. 

Profit estimates have been rising this year and continued to be upgraded in September, despite soaring bond yields, suggesting a new disconnect between analyst expectations and the risks facing companies. But those projections may be closer to a tipping point, especially if economic growth slows and companies’ ability to pass on rising costs to consumers fades. 

The first warnings have already come. The Citigroup Inc. Earnings Revision Index for US and Europe — a quantitative measure of the number of upgrades relative to downgrades — fell deep into negative territory in September. 

“With macroeconomic data pointing toward a slowdown, it is rather likely that the earnings season will lead to downward profit revisions,” said Gilles Guibout, a portfolio manager at Axa Investment Managers in Paris. He expects lower stock valuations as likely to only provide a small cushion. “There is no reason to hope for an extension of valuation multiples, because long rates will remain high.”

With profit margins near record highs globally, bolstered post-Covid era consumer demand, any normalization in these could deliver a wake-up call for analysts and investors alike. Disinflation, higher inventories and sluggish new order intakes highlighted in PMI activity readings, especially in Europe, all point to more constrained profitability. 

“The next penny to drop is margins,” UBS Group AG strategists Gerry Fowler and Sutanya Chedda said in a note earlier this week. “The next wave of negative market reaction will stem from profit warnings as margins contract. Bad news will be treated as bad news again.”

–With assistance from Julien Ponthus.

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