Earnings season kicks off as inflation skyrockets
Inflation, interest rates, and Fed tightening were the key factors driving financial markets over the past two weeks.
In December, the US consumer price index surged at a 7% year-on-year pace, the largest increase in almost four decades. Meanwhile, the core CPI, which excludes volatile items such as food and energy, topped estimates, rising 5.5% for the same period.
The Fed is clearly behind the curve and needs to catch up with rising prices, and markets are pricing a high probability of four 25 basis points rate hikes in 2022.
That has led to sharp declines in growth stocks, particularly in the tech sector, which benefited the most from the low-interest rates environment over the past two years.
However, it’s time to turn attention to the earnings season to learn more about how US businesses fared in this environment and whether profit growth can be sustained over the foreseeable future.
The S&P 500 companies are expected to deliver a 22% earnings growth for the final quarter of 2021 following an increase of almost 40% in Q3 2021 and bringing an earnings growth of more than 40% for the full year. Energy, industrials, and materials are the sectors with the highest expected profit growth due to robust demand and surging prices.
Q4 2021 will likely be the last quarter with double-digit earnings growth after US firms managed a strong recovery from the pandemic. However, with earnings expected to return to a single-digit number, valuations will become the biggest challenge in the rising interest rates environment. The S&P 500 forward PE ratio sits currently at 21, well above the long-term average of 16. Now, near-zero interest rates justify this, but multiples need to contract as rates rise.
Any further increase in stock prices needs to be supported by earnings, not multiple expansions. This is likely to be the biggest challenge in 2022.
Another pressing issue for Corporate America is the supply chain disruptions and their impact on margins. Input prices and wages increased dramatically over the past 12 months, but firms managed to pass the cost to consumers due to the high post-pandemic demand, keeping margins well elevated. This will not be the case going forward as demand falls, so margins forecasts are a key determinant for future profitability.
As we head into quantitative tightening, profits must grow at a reasonable rate to keep equities attractive. There are currently many headwinds, and hence volatility is likely to be on the rise; however, its financial results and earnings guidance that will separate winners from losers.