Earnings Season and Macro Uncertainty: A Measured Assessment

Introduction

As of mid-November 2023, financial markets are navigating a complex interplay between a still-resilient earnings season and lingering macro uncertainty. Recent data releases have provided a glimmer of hope: softer inflation prints and signs that central bank tightening may be nearing its peak have helped ease some of the pressure that weighed on risk assets earlier in the year. Government bond yields have retreated from their recent highs, offering a tailwind for equity valuations. However, the tone from central banks remains cautious, and markets remain highly sensitive to any shift in policy language. This note provides a sober assessment of the current landscape, drawing on the information available as of 2023-11-13.

Market and Macro Context

The macro environment in November 2023 is characterized by a gradual cooling of inflation, particularly in the US and Europe. Core inflation measures have moderated, and market-implied expectations for future policy rates have adjusted lower. This has allowed government bond yields to ease from the multi-year highs seen earlier in the autumn. For example, 10-year US Treasury yields have fallen from above 5% to around 4.5% in recent weeks, providing a more supportive backdrop for equities.

Despite these encouraging signs, the macro outlook remains uncertain. Labour markets in many developed economies remain tight, and services inflation has proven stickier than goods inflation. Central banks, including the Federal Reserve and the European Central Bank, have emphasized that they will keep policy restrictive until they are confident that inflation is on a sustainable path back to target. This has kept the possibility of further rate hikes on the table, and markets are pricing in a prolonged period of elevated rates.

Earnings Season: Resilience and Caution

The third-quarter earnings season, which is largely complete in the US and ongoing in Europe, has shown a degree of resilience. Aggregate earnings have generally exceeded lowered expectations, particularly in the technology and healthcare sectors. Companies have benefited from cost-cutting measures, pricing power, and in some cases, resilient demand from certain end-markets. However, the tone of forward guidance has been notably cautious. Many management teams have highlighted the uncertain demand outlook, the lagged effects of higher interest rates, and the potential for margin compression.

In the US, the financial sector has been a mixed bag. Large banks reported solid net interest income but flagged rising provisions for loan losses, reflecting the deteriorating credit environment. Consumer-facing companies have pointed to a more cautious consumer, with some signs of trading down to cheaper alternatives. In Europe, the energy sector has seen a pullback in profits from last year's elevated levels, while industrials have been supported by strong order backlogs.

Overall, the earnings season confirms that corporate fundamentals remain reasonably healthy, but the forward-looking picture is clouded by macro uncertainty. The ability of companies to maintain margins and revenue growth in a slowing economy will be a key theme in the coming quarters.

Implications for Investors

Given the current backdrop, a measured approach to portfolio positioning is warranted. The easing of bond yields and the resilience of earnings provide some support for equities, but the macro risks are not yet resolved. Investors should consider the following:

• Quality and defensives: Companies with strong balance sheets, stable cash flows, and pricing power are better positioned to weather a potential downturn. Sectors such as healthcare, utilities, and certain technology sub-sectors may offer relative stability.
• Duration and fixed income: The decline in bond yields has boosted the appeal of longer-duration fixed income, but investors should be mindful of the risk that yields could rise again if inflation proves persistent. A barbell approach, combining short-term and long-term bonds, may be appropriate.
• Diversification: With cross-asset correlations potentially shifting, maintaining a diversified portfolio across geographies and asset classes remains prudent. Emerging market equities and bonds may offer value, but they carry their own risks related to currency and geopolitical factors.
• Cash as an option: Elevated short-term interest rates mean that cash and cash equivalents offer a reasonable return with low risk. Holding some cash provides optionality to deploy capital if opportunities arise from market dislocations.

Risks to Watch

Several risks could disrupt the current narrative and lead to renewed market volatility:

• Central bank missteps: If inflation reaccelerates or remains sticky, central banks may need to tighten further than currently anticipated. This could reverse the recent decline in bond yields and weigh on equities. Conversely, if they ease prematurely, they risk losing credibility and allowing inflation to become entrenched.
• Geopolitical tensions: Ongoing conflicts in Ukraine and the Middle East, as well as US-China trade frictions, could disrupt supply chains, boost energy prices, and dampen business confidence. These risks are difficult to model but can have significant market impacts.
• Credit conditions: The lagged effects of higher interest rates are beginning to show in rising delinquencies and loan losses. A sharp tightening of credit conditions could amplify an economic slowdown, particularly in sectors like commercial real estate and high-yield credit.
• Earnings downgrades: While third-quarter earnings have been resilient, forward guidance has been cautious. If fourth-quarter and 2024 earnings estimates are revised down significantly, equity valuations could come under pressure.

Closing Thoughts

As of 2023-11-13, the macro landscape is one of cautious optimism tempered by persistent uncertainty. The combination of softer inflation data and easing bond yields has provided a more constructive backdrop for risk assets, and earnings season has shown that corporate fundamentals remain intact. However, markets remain sensitive to central bank language and the path of policy rates. Investors should avoid complacency and instead focus on building resilient portfolios that can withstand a range of outcomes. The next few months will be critical in determining whether the recent improvements are sustainable or merely a pause in a longer adjustment process.

In this environment, a disciplined, long-term approach that emphasizes quality, diversification, and risk management is likely to serve investors well. While the temptation to chase short-term moves is understandable, the risks remain elevated, and patience is warranted.