On one hand, the latest corporate earnings reporting season has been typical. Earnings and sales surprises were modestly positive, in line with historical averages. On the other hand, the evolution of earnings estimates subsequently has been more unusual.
European companies have actually put up better second-quarter results than US ones (see Exhibit 1).
This is unusual historically, and seems even more surprising now given the surge in energy prices in Europe and worries over gas supply cut-offs and recession. US interest rates have risen by more, however, and that seems to be having the Federal Reserve’s intended impact (i.e., to weaken demand and thereby inflation).
US forecasts are lagging
The perverse benefit of the greater increase in energy prices in Europe than in the US is that profits in the sector have risen by more, but even excluding the energy sector (as well as the financials sector, which had negative year-on-year earnings growth after the strong 2021 results), earnings growth overall still easily outpaced that in the US.
Perhaps aided by the unexpected surge in tourism and a weak euro, earnings surprises were also greater in Europe. As analysts update their forecasts for full-year results to reflect the latest reports, one would expect the estimates to rise in sync. This is more or less what has happened; estimates for 2023 have also been bumped up, if not by as much.
What is surprising is that US earnings expectations have not done the same. Although reported earnings have surprised to the upside in the US as well, analysts’ earnings revisions have been to the downside (see Exhibit 2).
Tech outlook tied to rates
Much, although not all, of the difference can be explained by the technology sector (including internet retail and entertainment).
Some of the biggest negative surprises were concentrated in this sector. The negative earnings revisions that ensued were commensurately larger given the previously high level of expectations. Look at revisions for the rest of the MSCI USA index (the orange line in Exhibit 2), and the pattern is closer to Europe’s, especially when one takes into account the volatility of estimates in the region.
There is an additional risk to the tech sector.
Markets have recently paid more attention to the slowdown in economic growth than to still-high inflation. As a result, market expectations for the level of the benchmark fed funds rate in a year’s time had dropped to as low as 2.8% from a high of 3.9% in mid-June. The decline was mirrored in real yields.
That is generally beneficial for tech (and growth) stocks, given that a greater share of their earnings is further out in the future and hence more sensitive to interest rates.
We believe the message and actions of the main central banks will increasingly focus on inflation as it has remained strong and persistent. As that happens, rate expectations and real yields are likely to rise: fed funds forecasts have already risen by 30bp over the last week and we believe there is further to go.
As markets adjust their outlook for policy rates, tech shares could come under greater pressure.