(Bloomberg) -- A looming recession, runaway inflation, an energy crisis in Europe and a euro that’s sunk to near parity with the dollar: corporate earnings worldwide face a laundry list of challenges this season that could create another reason to dump stocks.
After a tumultuous first half for global equities, with $18 trillion in value wiped out, investors are anxious to see if profits are holding up or if companies will cut guidance amid the intensifying threats to demand. Businesses may use the dour economic picture to be even more conservative than otherwise about the future.
In an unusual divergence of opinions, Wall Street analysts appear to believe companies are largely in a strong position to pass on higher costs to consumers, but strategists -- more cautious after getting their forecasts for 2022 wrong so far -- aren’t convinced. They have plenty reason for doubts, with the macroeconomic backdrop deteriorating amid surging prices, higher interest rates and lower consumer confidence.
“It’s bizarre that when everyone is talking of a potential recession, analysts’ earnings forecasts have been going up in the last few months instead of down,” said Anneka Treon, managing director at Van Lanschot Kempen. “It just doesn’t add up and that’s why this earnings season is so important in terms of profit margins and management commentary on the latest demand trends they are seeing.”
Energy is expected to be the standout sector as oil producers as well as miners have benefited from surging prices amid the war in Ukraine. Still, guidance from giants such as Exxon Mobil Corp (NYSE:XOM). and Shell Plc (LON:RDSa) will be critical after oil prices dropped back to around $100 a barrel. And for every other sector, higher commodity prices mean a bigger energy bill, dulling the picture for earnings overall.
And while net margin estimates are still hovering near all-time highs, there are cracks appearing. A Citigroup Inc (NYSE:C) index shows global earnings downgrades are now outnumbering upgrades at an increasing pace.
With sentiment among stock traders already gloomy, here are five things investors are watching in the second quarter-earnings season that may determine whether there’s a rebound or a drop to new lows.
Inflation Damage
When it comes to pricing power, luxury goods firms are in a good position thanks to solid demand, according to Morgan Stanley (NYSE:MS), which says that Gucci-owner Kering (EPA:PRTP) SA hiked some prices last month by 7% versus February. But that could come under pressure if management commentary suggests a slump in sentiment is translating into lower demand, strategists said.
That’s a worry across the consumer sector. The drumbeat of recession warnings may eventually force a change in household behavior, limiting pricing power and the capacity to protect margins. Some investors bet that megacap technology companies with their massive scale are better positioned to maintain growth and absorb pressures.
As consumers cut costs by opting for cheaper staples, which have lower margins to begin with, companies that sell to the mass market are likely to struggle the most, said Marija Veitmane, senior strategist at State Street (NYSE:STT) Global Markets.
Even banks, which generally benefit from rising real yields, will find it hard, Veitmane said, as “the flatness of the yield curve could negate the benefits of rising interest rates and keep net interest margins low.” Not everyone is bearish on the sector, however, with top fund managers at Amundi SA and BlackRock Inc (NYSE:BLK). saying last month that European banks in particular were attractive.
The ‘R’ Word
With the slump in stocks coinciding with a recent decline in Treasury yields and weaker oil prices, investors have already positioned for a “recession trade.”
They may be keen to hear what companies have to say about the rest of the year, but they’re already hoarding cash and hiding in bonds. Nearly $63 billion flowed into cash in the week through July 6 alone, while global equity funds had redemptions of $4.6 billion.
Ken Langone, the head of Home Depot Inc (NYSE:HD)., said Wednesday that the US is already in a recession, adding his voice to the litany of such views already out there.
“Some companies might use the general gloom as cover for any bad news that’s been lurking in the shadows,” said Danni Hewson, financial analyst at AJ Bell.
Thomas Hayes, chairman at Great Hill Capital LLC, says that a “kitchen sink quarter is certainly possible,” though he noted that more companies would have cut guidance going into the season if that were going to be the case.
China Crunch
In China, the guidance from dozens of preliminary earnings reports -- mainly materials and energy firms -- has been positive, but scrutiny over the areas worst hit by virus-related curbs will be key this season. Earnings estimates for mainland-listed companies were cut during the first five months of the year, which reduces the implied profit growth for 2022 to 22% from 31%, according to Haitong Securities analysts including Xun Yugen.
Construction materials and steel are expected to be among the laggards due to sluggish property sales and delays in construction, according to Northeast Securities analysts, while consumer firms could also see a big impact from Covid restrictions.
Those measures are also affecting US firms including Starbucks Corp (NASDAQ:SBUX). and Canada Goose Holdings (NYSE:GOOS) Inc. In late June, Nike Inc (NYSE:NKE). gave a downbeat full-year forecast, citing the China closures. Measures that affect factories in China also have ripple effects elsewhere, hitting supply chains and the availability of components and raw materials.
Europe’s Energy Problem
Earnings at S&P 500 energy companies are expected to have more than tripled in the second quarter, according to data from Bloomberg Intelligence. That compares with an average of 4% for all S&P firms.
Although oil prices have recently weakened again, strategists at JPMorgan Chase & Co. (NYSE:JPM) and UBS Global Wealth Management remain bullish on the sector.
But as Europe spirals into an energy crisis amid declining supplies of natural gas from Russia, businesses, particularly in Germany, are worried about power shortages as winter approaches. Pictet Asset Management this month downgraded euro-area stocks due to the energy squeeze.
The outlook for the region’s utilities is also grim, and governments are taking drastic measures. France is nationalizing nuclear giant Electricite de France SA (EPA:EDF), and Germany is in talks with gas firm Uniper SE (OTC:UNPRF) about a rescue package.
Disappearing Euro
The slump in the euro could also upend earnings for both European import-heavy companies and US firms who rely on the bloc for parts. Europe’s companies that could be hurt include utilities and travel and leisure, but export-oriented sectors such as automakers, industrials and chemicals would benefit, according to Joachim Klement, head of strategy, accounting and sustainability at Liberum Capital.
For Germany’s export-heavy economy, though, the tailwind may not be as pronounced because of its exposure to China’s supply chain as well as its cyclical nature. “I fear that the benefits of a weaker euro are going to be overshadowed by the deterioration in the macroeconomic outlook,” said James Athey, investment director at Abrdn.
The other side of the trade is the US dollar. It’s gained against all major peers this year, and the Bloomberg dollar index is up 9%. Worries about currency moves have weighed on Big Tech companies in the US, including Microsoft Corp (NASDAQ:MSFT)., which warned last month that a strong greenback would hurt its profitability in the second quarter.
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