Posted 20 February 2023
Overview: markets acknowledge the enduring stickiness of inflation
After a surprisingly strong start to the year in January, February has brought market consolidation rather than a continued uptrend – despite the FTSE100 finally passing the psychologically important threshold of 8,000 points. In last week’s digest we wrote that the prevailing ‘Goldilocks’ market sentiment of not-too-hot (growth, inflation), not-too-cold (rates coming down again soon) was being replaced by a more realistic view that rates will in all likelihood have to stay higher for longer than previously hoped. Inflation is stubbornly persistent – even as goods and energy/commodity price rises have indeed proven to be transitory – and tight labour markets have carried so-called second-round effects from last year’s price shock into the ‘stickier’ areas of goods and services.
Commentators from the US Federal Reserve (Fed) and the European Central Bank (ECB) have added further evidence to this view, as both said last week that central banks need to do more in their fight against inflation. This came after US consumer price index (CPI) inflation data contained both good and bad news, whereas the producer price index (PPI) inflation data showed a worrying uptick. Worrying, because falling raw material and energy costs were not enough to counterbalance price rises from rising labour and other input costs. While global government bond yields rose quite sharply after the central bank comments, they are not yet making investors fear recession is imminent. Credit spreads – for us the best indicator of fears of a recession – rose slightly last week, but are still close to the lowest levels of the past six months.
That said, the rise in bond yield levels may push the resumption of profit growth out towards 2024, which makes equities once again look relatively expensive and therefore vulnerable to corrections. This means that while we remain optimistic for the 2023 central scenario, we are more cautious for the near-term and have been taking the opportunity to lock in some of the attractive yields this period of uncertainty has brought. The shift in perspective has not necessarily changed the long-term picture of a relatively benign economic slowdown. Rather, the past weeks’ data points have injected a dose of realism into market sentiment.
Falling profit margins meet declining inflation
The last few company earnings reports for 2022 are trickling in, and at the aggregate level they look pretty bad. US companies took a big hit in the last three months of the year, and overall profits are either lower or roughly the same as in 2021 – depending on which measure you use. Relative earnings growth for the next twelve months (the rest of 2023 and the start of 2024) has also been revised down. For US equities, average earnings per share (EPS) is expected to grow by less than 4% compared to the 12 months just gone. European companies are even more sluggish, projecting 2.1% growth. By comparison, the historical averages for both US and Europe are around 11% EPS growth year-on-year.
In the light of rising interest rates and consequent slowing growth across the world, investors are braced for recession. On the face of it, corporate results back up those signs. Still, sales growth slowed rather than fell in the fourth quarter of 2022. What caused the earnings declines were therefore compressing profit margins, which declined markedly. The simple explanation would be that wages and other input costs are growing faster than sales, while on the revenue side of the equation a certain level of price discounting has crept back in following the extraordinary pricing power suppliers enjoyed during the initial post-pandemic period. That matches up with the general stagflation story, as well as with central bankers’ concerns about potential wage-price spirals.
The relationship between inflation and corporate profits is not straightforward, but in general you would expect inflation to cut into a company’s profit margins. The post-Covid episode seems to have differed from other potentially inflationary periods in that many companies appear to have raised prices on existing inventory rather than applying the price rises only to new stock. But regardless of why companies wanted to raise prices, it is still significant that they could. Moreover, the realisation that they could raise prices without choking off too much demand might mean firmer pricing power down the line. But in terms of the current outlook, it is important that rising margins were primarily a defensive move, coming from a position of expected weakness rather than strength. The opposite seems to be happening now, but for the same reasons. Profit margins are coming in, relieving a big chunk of the inflationary pressures we saw before. Whereas before, companies expected sharply higher costs and an okay short-term demand picture, now they see falling input costs and widespread talk of a recession. With sales growth already slowing, businesses likely feel the need to rein in prices – or at least hold them steady – to retain customers.
China’s post-pandemic recovery taking time to come through
Chinese investment assets have managed quite a turnaround over the last few months. Since November, China’s benchmark CSI 300 index has rallied by more than 15%, although gains over the last month have been harder to come by. Near-term confidence has probably been knocked by the spy balloon controversy, but markets are still clearly positive about Chinese growth this year. This is helping not only Chinese assets, but emerging markets more broadly. In fact, some market analysts have warned that buying into China’s reopening is becoming a crowded trade.
Despite the high degree of hope around China’s bounce, commodities have lately been surprisingly subdued. Copper, the industrial metal most sensitive to Chinese construction and technology production, rose sharply towards the end of last year. Since then, however, that rally has reversed somewhat. The same is true for energy, which gained momentum after the end of Zero-Covid, but has since cooled. This dynamic is also playing out across a range of industrial metals, including iron and palladium. Both are indicators of swings in the health of domestic vehicle demand. The fact palladium prices have come down is particularly interesting. While other metals point to the strength (or lack thereof) of Chinese industry, cars are more an indicator of consumer spending. Consumers appear to be slower than expected in regaining confidence.
In short, we have yet to see any conclusive signs of a strong post-Covid, post-regulatory crackdown bounce in China, despite the conducive conditions. However, we should not be worried yet that the 2023 Chinese growth spurt might fall short of expectations. When Beijing declared the end of Zero-Covid, we argued it might take some time for the results to show, in part because of seasonal factors. China celebrated its Lunar New Year at the end of January, and is only now coming to the end of its Spring festival – a month usually reserved for spending time with family, often away from the big cities. We said earlier this year that March might be the time when we see growth begin in earnest, and that is still possible. In terms of background conditions, the reopening bounce is very much on: it might just take a little longer to get going.