Though it is an uncertain time for equity markets around the world, some clear signposts are emerging. Photo / AP
OPINION:
In a world experiencing record levels of inflation and global equity markets down about 14 per cent (NZD) in the first half of the year, the US second-quarter earnings season was always going to be pivotal. Taking place from July through to August, it could either help buoy sentiment or weigh it down further.
A reflection of the current uncertainty in markets, expectations from analysts have been generally optimistic, while strategists and economists have reached a more negative consensus view.
With many US companies having now reported, we summarise three key factors that may help us glean insight into the possible direction from here for the US equity market. These also have the potential to impact investor sentiment around the world.
As we have already been seeing, the impact of inflation on businesses is not uniform.
The latest US consumer price index data showed an annual increase of 9.1 per cent for June, the highest inflation rate since 1981. As rising prices eat into many household budgets, there may be little wriggle room for mass market consumer brands or retailers to pass on their higher costs.
The earnings forecasts of retail companies and others over the next few weeks, alongside outlook commentary, should shed light into how they look to position themselves in the balance of passing on costs with what consumers are willing to pay.
A company's pricing power can depend on many factors, including the standing of its brand(s), the uniqueness of its products & services, and its scale. US big box retail businesses Walmart and Target recently issued profit warnings, citing shifting consumer behaviour as the costs of everyday necessities have increased. Walmart said it will need to reduce prices on general merchandise (like clothing and other discretionary items) to clear backlogs. It is due to report its results on August 16 (US time), where further details may be provided.
Mass-market retailers' margins are already facing pressure from supply chain issues and increases in transport costs due to the high oil prices seen this year. However, Amazon gave more upbeat guidance when reporting its second-quarter earnings at the end of July, where it also reported revenue that beat analyst expectations (according to Refinitiv). While it cited similar inflationary pressures as challenges, the company's CEO said it was making progress on "controllable costs". This includes the productivity of its fulfilment network, which encompasses inventory management. Amazon has also reduced its workforce by about 100,000 people, similar to many other major tech companies looking to lower costs.
At the opposite end of the brand spectrum, we're seeing luxury brand conglomerate Moët Hennessy Louis Vuitton (LVMH) passing through higher costs in the form of price increases for their products without denting sales volumes.
The scalability of mega-cap tech companies could help them to absorb some inflationary pressures. However, with 58 per cent of S&P 500 information technology company revenues sourced from overseas - according to FactSet – a strengthening US dollar could add additional headwinds.
The tech sector is not alone as a major US exporter, with materials deriving 56 per cent of its revenue from beyond the US. A stronger US dollar relative to many other currencies might mean there is less room for companies to pass on higher costs given the exchange rate is already raising the prices of their products for the countries importing them.
While the scale of the 'growth-oriented' technology companies could help them navigate higher costs, the central bank reaction could be what affects them the most. In an effort to quell inflation, the US Federal Reserve (Fed) is now taking an aggressive approach to raising interest rates quickly, much like the Reserve Bank of New Zealand. Most recently, in July, the Fed raised its benchmark rate to a range of 2.25-2.5 per cent – its second consecutive 0.75 percentage point interest rate increase.
The focus for many technology companies in the past decade has been to expand their earnings at an above-average rate and reinvest profits back into their business – aiming to grow capital value. They have previously had flexibility to do this, with low interest rates helping keep the cost of capital down.
A company's cost of capital is derived from the weighted average cost of all capital sources. This is calculated by averaging the cost of equity and debt issued by a company. Because growth companies are expected to generate increasingly larger cashflows into the long-term, expectations of future interest rate rises weigh on the value investors and analysts attribute to them today. Perhaps pointing to this, Apple's Chief Financial Officer stated that the company expects revenue to "accelerate" in the September quarter, when reporting its next round of quarterly results last month.
On the other hand, the likes of Meta (Facebook's parent company) and Twitter have found it difficult to boost their revenue and profits during the quarter. Both had results below market consensus, citing decreasing advertising demand and the broader economic environment as challenges. It will be interesting to see where and how companies may shift their attention, and how they might plan to accelerate the path to higher cashflows.
While supply chain issues look to be gradually easing, China's continuation of a zero-Covid approach means there is still a likelihood of future rolling lockdowns in the country. These may again prove to be disruptive to those US companies with manufacturing operations in China, or who rely on supply chains through cities like Shanghai to receive goods or components for their products.
Another pressure point for supply is the ongoing war in Ukraine. A significant amount of a major ingredient for semiconductor chip production, neon gas, was produced in Ukraine. These chips are vital components in a range of goods, from vehicles to smartphones and computers. With neon gas production suspended in Ukraine, it is proving harder to source in large volumes.
The manufacturing of chips is largely concentrated in Asia, where about 75 per cent of the world's chips are produced, according to the Semiconductor Industry Association. Taiwan Semiconductor Manufacturing Company (TSMC), the world's largest chipmaker, recently signalled "greater challenges in supply chains" as pushing out delivery times for some of its chipmaking equipment. The Taiwan-listed company is a major supplier to Apple and a range of technology and vehicle manufacturers.
TSMC has also delayed some of its capital expenditure "into 2023". While the company said it observed weaker demand in consumer goods like smartphones and computers, it has noted steadiness in the data centre and automobile markets.
These sentiments were also reflected further down the supply chain by US chipmakers AMD and Intel, which reported contrasting profit results. The former beat expectations for profit and revenue but gave a forecast below estimates for the current quarter. It outperformed competitor Intel, which has been experiencing execution issues and reported earnings below those expected by many analysts.
We will be watching how this relatively mixed outlook may impact US-listed technology and auto manufacturers further along the supply chain.
The geographical concentration of chip manufacturing is leading to a push by US companies and regulators to localise more production. The US Congress recently passed a US$52 billion ($80.5b) programme to provide assistance to the domestic semiconductor manufacturing industry. It also involves a condition for companies receiving the funding; that they do not increase their production of advanced chips in China.
The US CHIPS Act follows similar European legislation announced in February, which aims to increase Europe's share of semiconductor manufacturing from 10 per cent to 20 per cent by 2030. Earlier this year, Intel invested US$20b towards two new chip factories in Ohio.
The decision by Congress could also spur further announcements of production investment from companies over the coming months. It reflects the trend of reshoring supply chains, which is becoming increasingly prevalent as nations grappled with supply disruptions during the pandemic and while national security considerations are being impacted by deteriorating geopolitics.
Even though it is a generally uncertain time for equity markets around the world, some clear signposts are emerging. There are still plenty of possibilities and viewpoints on the trajectory for inflation, interest rates, the pandemic and geopolitical issues. However, when we come out of the latest round of US company earnings, we should have more information to put everything in context. It could even lay the foundation for the path ahead in global equity markets.
• Jeremy Ward is Vice President, Wealth Management Research at Jarden.
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