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Although markets do not always lead changing fundamentals, markets traded down ahead of weaker earnings in the first half of 2022. More recently, however, despite lower year-over-year results trickling in for the second quarter, many names have bounced off their lows. The rally suggests a belief that the worst may be behind us. We see a number of reasons to remain on defense, however.
Bank rates are still going up; consumers are still struggling with inflation; and many industries are seeing increased competition as growth slows. With these factors in mind, we think the true test will be third and fourth quarter results, for which second quarter results offer many warning signs.
Earnings … the ‘You are here’ of markets: With the S&P 500 having reported, we now know that as-reported second quarter earnings for 2022 were 11.7% lower year-over-year (YoY), representing the first quarterly drop since Q4 2020. Based on S&P Global data, on an YoY operating earnings basis second quarter earnings:
- Declined for: Financials (-78%), Consumer Discretionary (-22%), Communication Services (-17%), Real Estate (-11%), Consumer Staples (-9%), and IT (-4%).
- Advanced for: Energy (+347%), Industrials (+21%) and Materials (15%), and Health Care (+6%), while remaining flat for Utilities (0%).
Sector trends not surprising: The trends are consistent with the commodity-driven, inflationary environment we have been living through. Industrials are perhaps the lone outlier, as the sector made a delayed recovery from pandemic-induced supply chain issues.
Growth is still baked in: Despite the first half decline, analysts currently expect second half 2022 earnings to grow by 4% versus the second half of 2021. Notably:
- Growth is concentrated: Growth in the second half is expected from Energy (+83% YoY), Industrials (+31%), Utilities (+17%), Materials (+11%), Health Care (+10%) and IT (+8%).
- The consumer is expected to hold up: Consumer Discretionary (0%) and Staples (-2%).
- Interest rate sensitive sector earnings decline: Bigger declines are expected for Financials (-25%) and Real Estate (-23%).
- Advertising sensitive earnings decline: Second half earnings for Communications (-10%) are also expected to decline.
Equities remain expensive: If we look back to September 2019, pre-pandemic, the market was paying roughly 19.3x forward twelve-month earnings estimates, when inflation was still tame and U.S. 10-year Treasury yields stood at 1.9%. The market is now paying roughly 20.1x forward estimates, with 10-year yields up to 3.3% and central bank tightening still to come.
With interest rate hikes continuing, and inflation squeezing corporate margins and the consumer, we see a high likelihood of a second half earnings decline, rather than the 4% growth currently anticipated. If earnings waver and/or the current global economic slowdown picks up pace, equities’ valuations could fall sooner rather than later.
As a result, we remain focused on investing in high quality companies with strong free cash flows, clean balance sheets and proven management teams. To this end, we continue to benefit from the ideas generated by our affiliate Veritas Investment Research Corporation, which consistently ranks among the best research shops on the street.
Year-to-date through August 31, 2022, the NASDAQ was down 24.1%, the S&P 500 was down 16.1% and the S&P/TSX was down 7.2%. Over the same period, our Canadian Equity Fund fell 4.0% and our Absolute Return Fund was 8.5% lower. (Performance based on F series).
We remain focused on capital preservation during the current market volatility while pursuing opportunistic investments to drive returns.