With the bulk of earnings season now out of the way, and bond prices rallying, is there reason for investors to be optimistic?
As always, earnings season has proven decisive for the stock market, with the cream rising to the top during what has otherwise been a difficult year for the stock market.
However, it isn’t just a host of high-profile names that are acting as the catalyst for the recent market rebound.
In fact, a strong trend that we anticipated is unfolding in the bond market, and it is giving us reason to be somewhat optimistic that the worst could be behind us.
Earnings paint a not so scary picture
The latest earnings from big tech in the US have largely supported the stock market, avoiding worst-case scenarios that investors had feared back in June only weeks out from the start of reporting.
For the most part, the results have been solid if not unspectacular. But such was the level of concern before earnings season started, even a few revenue and earnings misses went unpunished because the stocks had been oversold in the lead-up.
In the context of the current macroeconomic landscape, it appears as though treading water has been sufficient to consider the latest earnings season a ‘success’.
Inflationary pressure and supply chain woes have been a persistent headache across the tech sector, as have other issues like an advertising slowdown, fall in personal computer sales, and a knock to consumer spending.
Nonetheless, it is the growing area of cloud computing that remains a buoyant theme. This theme was responsible for providing a strong tailwind to companies such as Amazon (AMZN), Microsoft (MSFT), Alphabet (GOOGL), and even Apple (AAPL).
Each of these names are seeing strong double-digit growth directly from the cloud, and it indicates that while big business is prepared to cut back on advertising, it is showing its unwavering commitment to the cloud.
At the same time, this is also offsetting weakness in the consumer channel. That means cloud computing is becoming the most important barometer for earnings as businesses adjust their spending, and while individuals are now seemingly beyond the upgrade cycle for computers, new smartphones, and the like.
Microsoft CEO Satya Nadella summed up the pivot to the business, arguing the company “will be exposed to consumer-driven businesses, but at some level, our strength as a company is much stronger in the core commercial”.
Elsewhere, we’ve also seen strong results from semiconductor stocks, with demand from the automotive and industrial sectors offering a good outlook moving forward.
Even digital payments processors are finding favour again, with PayPal (PYPL) one company pointing to a strong profit outlook despite numerous headwinds in play.
Where we have seen weakness, however, is among stocks tied to consumer spending, including Walmart (WMT) and Shopify (SHOP), and companies that are overly dependent on advertising revenue.
Yes, some mega-tech names also generate earnings from advertising, and have been impacted by the slowdown, but here we are talking about social media sites that effectively rely on advertising to underpin earnings growth. On this point, think Meta Platforms (META), Snap (SNAP), and Twitter (TWTR).
Meanwhile, if you look beyond the headline figures, it is our view the bank sector is offering hope to investors as well.
There may be uncertainty ahead regarding the US and global economy, but second-quarter earnings suggest much of the slump in profits across major banks was driven by non-interest income.
For example, weaker returns in areas like investment banking, venture capital, and so forth. These areas are shaped by market activity, and with the environment being exceptionally difficult over recent months, the slowdown shouldn’t come as a surprise.
On the contrary, consumer deposits remain healthy, loan activity is still in good shape, while reserves are being bulked up. In our opinion, all of this detail suggests the situation is not as concerning as the headline figures may suggest.
Bond prices rally as interest rate expectations are wound back
As we forecast in our recent commentary, bond yields have started to come off recently amid a rethink of interest rates.
The US 10-Year Treasury Yield has declined from a high of around 3.5% back in mid-June, to as low 2.58% recently, although since moving about on upbeat data regarding the jobs market.
Nonetheless, this material devaluation in yields, or more appropriately, this re-rating of bond prices is what we believe is a reflection of an interest rate outlook that is less aggressive than the market expects.
There are further signs that inflation is already likely to have peaked, with commodity prices retreating rather hastily throughout July. It hasn’t just been mining metals either. Other commodities like lumber, wheat, and corn are now well off their highs, and we expect that to flow through to consumer prices.
Combined with a cooling housing market, both in Australia and overseas, we are inching closer towards being out of the woods in terms of the worst of inflation.
That is not to say there are no risks ahead. However, we believe there are enough positives in play. In the meantime, it reaffirms our view that terminal interest rates may be less than the market is forecasting.
We have already seen the US Federal Reserve go hard on rates courtesy of 75 basis point hikes at its most recent meetings.
Some may say this was too late, and that is largely a different point altogether, but with underlying drivers now likely to help cushion the effects of inflation, the pace at which rates increase from here could moderate.
There is little doubt in our mind that there are still various rate hikes to follow. However, what we believe could unfold is the Fed may look at lifting rates at a slower rate, perhaps starting with 50 basis points at its next meeting, before reassessing from there.
Again, it would seem the market is starting to come around to this prospect, or at least the prospect that terminal interest rates in this hiking cycle may not be as high as feared.
This goes to the heart of why bond prices have started to rally. Much of the work done to adjust monetary policy may now benefit from a slightly less hawkish approach to determine how effective it has been to date, especially with a commodity pull-back set to help.
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