The market is “too optimistic” in its outlook for corporate earnings, analysts at BlackRock have warned, so investors should prepare for further volatility if they disappoint expectations.
In a recent note, the asset management firm – which is the largest in the world – revealed that it has turned away from stocks on a tactical basis and currently sees more opportunities in investment grade bonds.
The latest update from the BlackRock Investment Institute adds that part of the reason for this stance is the expectation that earnings growth will start to disappoint investors.
“The pandemic and unique restart of economic activity brought about a massive re-allocation of resources. During the pandemic, consumer spending shifted to goods and away from services. That propped up goods producers’ earnings,” the firm said.
“That’s changing, in our view. Goods demand is weakening. Overstocked inventories, from retailers to semiconductor firms, are evidence of that. Meanwhile, spending is returning to services. This shift could hit stocks.”
BlackRock explained that this is because earnings linked to goods are expected to make up 62% of S&P 500 profits this year, versus 38% tied to services. However, goods account for less than one-third of the US economy.
Goods and services split for US economy and S&P 500 earnings
Source: BlackRock Investment Institute, with data from Refinitiv Datastream and US Bureau of Economic Analysis, August 2022
“This means a boom in services doesn’t power S&P 500 earnings as much as it does the economy,” it added.
Furthermore, the labour shortage that has been in place since the pandemic means that companies will have to start offering higher wages to attract people back to the workforce. But this will increase their costs, put pressure on margins and hit earnings.
The economic backdrop also looks gloomy with the US undergoing a contraction and Europe expected to go into recession because of the energy shock stemming from Russia’s invasion of Ukraine.
“What does all this mean for earnings? S&P 500 earnings growth has essentially ground to a halt, we calculate, if you exclude the energy and financial sectors. That’s down from 4% annualised growth last quarter, Bloomberg data show,” BlackRock said.
“What’s more, we believe analyst earnings expectations are still too optimistic. There are huge differences between sectors.”
The investment implications of this, according to the asset management giant, is that the rally that has buoyed markets in recent weeks could be at risk.
BlackRock thinks that hope the Federal Reserve will pause its interest rate hikes is premature and the rally will peter out when investors realise this. The risk that earnings will disappoint as spending shifts towards services adds more pressure.
“Our bottom line: We are cautious in the short run but are staying invested. We tactically prefer investment grade credit over equities because we think it can weather a slowdown that equities haven’t priced in yet. We remain underweight most developed market equities on a tactical basis until we see clear signs of a dovish central bank pivot,” BlackRock concluded.
“We like selected healthcare and energy stocks. We are cautious on tech stocks for now due to their sensitivity to higher rates. We do see strategic opportunities in tech and in healthcare as they’re set to outpace carbon-intensive sectors in the energy transition.
“Within sectors, we prefer quality firms with the ability to pass on higher costs, stable cash flows and strong balance sheets.”