The Three Themes That Will Dominate This Earnings Season

The Three Themes That Will Dominate This Earnings Season
Carl Hazeley

almost 2 years ago4 mins

  • The outlook for consumer demand will be important throughout the rest of the year, and the Consumer Discretionary Select Sector SPDR Fund is one way to bet on stronger-than-expected demand.

  • Inflation and supply chain issues are threatening company profit margins, so betting on firms with high and stable gross margins should help insulate you from those set to lose out.

  • Companies are counting the costs of geopolitical risk, and US companies that make most of their sales domestically have been outperforming those with a large global footprint.

The outlook for consumer demand will be important throughout the rest of the year, and the Consumer Discretionary Select Sector SPDR Fund is one way to bet on stronger-than-expected demand.

Inflation and supply chain issues are threatening company profit margins, so betting on firms with high and stable gross margins should help insulate you from those set to lose out.

Companies are counting the costs of geopolitical risk, and US companies that make most of their sales domestically have been outperforming those with a large global footprint.

Mentioned in story

This earnings season is going to be grimmer than the ones we’ve got used to, with S&P 500 companies expected to have grown profits by an average of 5% on the same time last year – down from 27% last quarter, and 48% a year ago. But by identifying the three big themes that are likely to dominate this season, you can still find a few diamonds in the rough…

Theme 1: Consumer demand

The recent yield-curve inversion has brought recession risks to the top of investors’ minds, and it’s got people thinking about how consumers are doing. See, consumer spending makes up 70% of the US economy, so any sign that their spending is dropping off is cause for concern.

And there are signs that consumers are being squeezed by sky-high food and energy prices, leaving them with less to spend on nice-to-haves. That’s partly why consumer discretionary companies are expected to show a 13% decline in first-quarter profit versus the same time last year. Rising labor costs and supply chain issues haven’t helped these companies’ bottom lines either, mind you.

But a recession isn’t inevitable: companies have a lot of cash on hand and so do US households, thanks in part to government support during the pandemic. In fact, there’s arguably a post-pandemic spending boom due, which could stave off a major economic slowdown.

The opportunity:

The US consumer discretionary index is down more than 12% this year (versus the S&P 500’s 7%), even though analysts have only cut their 2022 annual profit forecasts by 2% on average (versus +2% for the S&P 500). That suggests betting on a more resilient consumer could be profitable. One way to do that is via the Consumer Discretionary Select Sector SPDR Fund (ticker: XLY, expense ratio: 0.1%). You could also use call options, which mean you pay less upfront to make the bet and limit your losses to the cost of buying the option in the first place.

Theme 2: Inflation

Data out on Tuesday showed US inflation reached a fresh 40-year high in March, with higher commodity prices, increased worker wages, and global supply chain issues all to blame. Those higher prices will still be with us for the rest of the year even if inflation begins to ease, so companies that can pass higher costs on to consumers without seeing a drop in demand (i.e. companies with strong “pricing power”) are likely to perform better.

The opportunity:

Breaking out the playbook Goldman Sachs published last year, you’ll want to own companies with high and stable “gross margins” and avoid any whose are low and variable. A rising gross margin over time suggests a company has pricing power.

The table below shows companies with a five-year track record of pricing power. Some of the biggest names include Alphabet, Nike, Johnson & Johnson, Oracle, and S&P Global.

High pricing power US stocks. Source: FactSet, Goldman Sachs.
High pricing power US stocks. Source: FactSet, Goldman Sachs.

Below are the companies you might want to avoid in this environment, as their track record suggests a lack of pricing power. Some of the biggest names here include General Electric, Raytheon Technologies, Walt Disney, and Lockheed Martin.

Low pricing power US stocks. Source: FactSet, Goldman Sachs.
Low pricing power US stocks. Source: FactSet, Goldman Sachs.

Theme 3: Geopolitical risk

Between the pandemic and the war in Ukraine, companies have been forced to reevaluate their global footprint. Some firms have brought their supply chains closer to home, while others have shuttered their operations in contentious regions. But that comes with a cost: energy giant Shell, for instance, just announced a $5 billion “write-down” of its Russian assets after its decision to leave the country.

The opportunity:

You might want to focus your investments in US stocks on those that do a large proportion of their business in North America, where the political climate is broadly stable. US companies with high domestic sales exposure have outperformed those with high European sales exposure by 10% this year.

Domestic US-focused stocks have been outperforming internationally-focused ones.
Domestic US-focused stocks have been outperforming internationally-focused ones.

Your best bet when it comes to identifying a US company’s sales exposure is its annual filing with the US financial regulator (here). You can also check out a company’s investor relations website (by searching the company’s name followed by “investor relations”). But to get you started, here are a few household names that might be worth thinking about.

Verizon, Target, Wells Fargo, Intuit, and CVS all make 100% of their sales in the US, so should benefit from the trend shown in the chart. On the other hand, Booking Holdings, eBay, and Philip Morris International make between 27% and 77% of their sales in Europe, meaning they’re more likely to underperform.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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