Financial update from Brewin Dolphin - 29 July 2022

July 2022

The Weekly Round-up

Friday 29 July 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses a busy week of US corporate earnings and the Federal Reserve’s latest interest rate hike.

Equity markets continued their recovery during the final week of July. Nine of the last ten Julys have been positive, with an average return of 2.3%, but this will be the strongest of them all. Volumes have been characteristically thin, leading to some exaggerated moves in stocks and broader markets. The unwinding of quantitative easing by the Federal Reserve, the Bank of England and now the European Central Bank has further drained liquidity from the markets.

Earnings season

This was the busiest week for earnings releases, and it finished with over half of the members of the major US and European markets having reported their results.

In terms of headline statistics, the share of companies beating earnings forecasts has been a little below normal at just over 70% in the US (it is normally 80%). The size of the average earnings beat is the smallest since 2020 – even after the onset of Covid, companies managed to beat their estimates, which perhaps reveals why this is the wrong way to judge the strength of an earnings season.

A better way is to look at the results that companies are achieving. The sector facing the biggest challenges was financials, despite rising interest rates and a temporary boost from trading. Financials stocks faced challenging comparisons and reduced investment banking fees. On average, US earnings declined in the second quarter. Sales, by contrast, grew fairly briskly.

A lot of the information that earnings season provides is about the outlook. This was quite changeable. As we discussed last week, financial companies have reported that consumers are still spending well, have adequate cash balances, and show few signs of stress. Part of the reason for high levels of spending is, however, the high price of goods and services. Hence, when listening to retailers, there does seem to be a more cautious tone. So the focus has also been on retailers to see what people are buying.

Still spending?

Amazon sounded pretty upbeat on consumer spending – both now and in the future. However, Walmart has been acting as something of a bellwether for US retail sales over the last decade. It tends to cater for lower-income households and has seen its sales mix shifting from general merchandise towards groceries. This suggests that price increases in life’s essentials are beginning to feel the pinch from higher prices for non-discretionary spending.

While this may bode ill for the future, the present seems pretty reasonable. US gross domestic product (GDP) did contract for a second quarter in a row and that may yet end up being defined as a recession, but most people think it probably doesn’t quite fit the definition. That was validated by the fact that consumption continued to expand in the second quarter. The factor dragging growth downwards was the fact that companies liquidated their inventories.

Anecdotally, inventory sales seem most likely to reflect a misjudgement of demand for goods, which was high during lockdown and slipped once the economy reopened and more services became available. Supply chain issues may have also prompted more companies to over-order. However, in some cases it likely reflects some nervousness about demand over the coming months. The Conference Board consumer survey showed a continued slump among consumers who may want to make large purchases.

The Conference Board also revealed that the lowest share of consumers in more than a decade plan to buy a home in the next six months. Housing is another bellwether for the economy as it has a high multiplier – with each house built, there is a lot of economic activity (construction, decoration, sale, moving, furnishing, and so on). Consistently weak housing data, including sharp reductions in new and pending home sales, suggests that higher mortgage rates and high prices are discouraging new housing activity. Residential investment (housebuilding) was the other contracting category within the Q2 US GDP report.

Still tightening?

Despite the uncertainty, the Federal Reserve pressed ahead with a 75-basis point interest rate increase. There was little question of it doing so. Just as with companies, the market was keen to hear Fed chairman Jay Powell explain what the central bank was planning to do next. Powell said another unusually large hike could be appropriate at the next Fed meeting, but it would depend upon the data. This new stance of data dependency was greeted positively by the market, which sees evidence of the economy slowing and was already sceptical that the Fed would be able to reach its expected interest rates trajectory of 3.8% by the end of 2023.

Bonds and equities rallied at this apparent sign that Powell was ready to respond to falling inflation and a slowing economy, but they may be being premature in this assessment. Food inflation should slow in response to falling soft commodity prices, and some shortages are being addressed with manufacturing supply times shortening. But the labour market remains tight and house price growth has remained rampant, supported by shortages of supply, even as demand has ebbed.

Still growing?

In contrast with the US, eurozone GDP expanded much more than expected in the second quarter, driven by pent-up tourist activity in Spain and Italy, while household spending was still resilient in the region. But Germany stagnated, reflecting challenges in exports and industrial activity as global, and particularly Chinese, demand slowed.

Despite the better Q2 reading, the data is backward looking. More high-frequency data, such as business surveys, suggest private sector activity contracted in July and business confidence slumped to levels not seen since the global financial crisis.

Meanwhile, inflation has not seen a peak yet, with the latest eurozone CPI rising to 8.9% from 8.6%. Aside from surging energy costs, underlying prices (core CPI) also accelerated. The spike in natural gas prices in recent weeks means energy prices will remain a big challenge for consumers and businesses as winter looms.