Weekly market commentary

Three takeaways from U.S. earnings

Market take

Weekly video_20230814

Wei Li

BlackRock Global Chief Investment Strategist

Opening frame: What’s driving markets? Market take

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Earnings have been stagnating and this past quarter, they came in better than feared.

Title slide: Three takeaways for U.S. earnings season

1: Margins squeeze?

So, heading into this season, I was paying very close attention to if companies are able to keep and maybe even grow their margins, and the answer is yes. But, looking ahead headwinds to margins include labor shortage, tight supply as well as sustained wage growth.

2: Dispersion and selectivity

The second point I would note is this huge dispersion and the importance of selectivity that came through in the earnings picture as well.

So, looking at what has been contributing to earnings upside, we are talking about typically early-cycle sectors like consumer discretionary, for example. Which in the context of labor’s greater share of the pie is not entirely surprising.

I am specifically paying attention to if tech names are able to meet the very high bar as they came into this reporting season. And the answer is also yes, as they surprised versus the even elevated expectations, which is why they continued to hold up in terms of performance.

3: Regional nuance

And the third point I would note is around regional nuance. So, Europe versus U.S. If you look at the absolute year-on-year growth, European equity market versus the U.S., European earnings have contracted twice as much as U.S. equity market this past quarter, which also contributed to European equities losing the relative outperformance earlier in the year, when European exceptionalism was contributing to performance.

Outro frame: Here’s our Market take

Closing frame:

Read details: www.blackrock.com/weekly-commentary

Earnings outlook

U.S. corporate earnings have stagnated for a year, but Q2 beat a low bar. Expectations of improving margins look rosy. We stay selective in equities.

Market backdrop

U.S. stocks moved sideways and 10-year Treasury yields surged in volatile trading last week after CPI data. We see inflation on a rollercoaster ahead.

Week ahead

We’re watching inflation in Japan this week after the central bank loosened its yield cap last month. We see that pulling local and global bond yields higher.

U.S. corporate earnings have stagnated over the past year even as Q2 earnings improved a bit on better profit margins. We still see a margin squeeze ahead as worker shortages push wages back up, even if that takes longer to play out – our first takeaway. So the consensus for margins to expand into next year looks rosy, to us. Second, we see clear sector winners and stay selective with and within sectors that delivered earnings growth. Third, we see key regional divergences.

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Investment themes

Holding tight

We believe supply constraints will keep inflation sticky and compel central banks to keep policy tight long term. We think this new economic regime provides different but abundant investment opportunities.

Pivoting to new opportunities

Greater volatility has brought more divergent security performance relative to the broader market. We think that creates other opportunities to generate returns by getting more granular with exposures and views.

Harnessing mega forces

Mega forces are shaping investment opportunities today, not far in the future. We think the key is identifying catalysts that can supercharge these forces and how they interact with each other.

Profit pressure ahead
U.S. NFIB survey selling prices and wages vs. S&P 500 margins, 2020-2023

Source: BlackRock Investment Institute and NFIB, Refinitiv Datastream, August 2023. Notes: The dark orange line shows the net percentage of respondents reporting higher average selling prices based on the NFIB Small Business Economic Trends survey. The yellow line shows the share planning to increase worker compensation in the next three months.

U.S. earnings have stagnated over the past year as pandemic-driven spending shifts normalized, squeezing profit margins. Margins ticked up in Q2, so earnings topped low expectations, partly from companies benefitting from lower input costs. We don’t think this will last. The consensus for profit margins looks too rosy – our first takeaway from Q2 earnings (green line in chart). Firms may struggle to pass on persistent labor costs to consumers: The share of businesses reporting higher prices for their products is the lowest since January 2021 (dark orange line), NFIB data show. We see companies facing higher labor costs from lifting wages to attract fewer available workers: The workforce is 4 million smaller than it would have been if it had kept growing at its pre-Covid pace, we find. The recovery of jobs lost in the pandemic has masked what has proved tepid job growth. Competition for workers should boost employee wages – at the expense of profit margins and shareholders.

We believe this structural labor shock is poised to take over as the driver of inflation as the pandemic-driven spending mismatch unwinds. That historic shift in consumer spending during the pandemic to goods from services created mismatches in production and consumption, and within the labor market as a result. It drove up prices and led to fatter profit margins, especially in the goods sector. Recent data showing a further sharp drop in goods prices in the July U.S. CPI and cooling Q2 wage data confirmed spending is normalizing. And that means profit margins are starting to normalize as well, even with the slight improvement in Q2.

Varied results

As worker shortages due to an aging population become more binding, we see firms needing to devote revenue to hiring or retaining workers – to the detriment of margins. We see inflation on a rollercoaster as the labor shock takes over from the spending mismatch. If companies try to protect margins from these wage pressures in a stagnant economy, that could add to inflation pressures and result in even higher central bank policy rates. We have evolved our macro framework to account for these forces.

Our second takeaway from Q2 earnings season: Tech met a high bar and selectivity is coming through in earnings. Other sectors that perform well as economic activity picks up fared better than expected, like industrials, communication services and consumer discretionary. As U.S. growth stagnates, it would be logical to question consumer sector resilience – especially as pandemic savings dwindle. But that’s the old playbook: The sector impact may be different. We think workers gaining income share from firms and unemployment staying low could reinforce consumer spending power for some time. We use our new playbook instead to get granular with and within equity sectors. Tech aligns with our preference for sectors delivering earnings growth. But we stay selective in tech with our overweight to the developed market (DM) artificial intelligence mega force theme, tapping into this structural shift within DM stocks, even when the macro is unfriendly to broad equity exposures.

Our last takeaway is regional differences. Q2 earnings of European firms contracted twice as much as U.S. peers, contributing to European stocks underperforming DM peers in recent months. Within DM, we prefer equities in Japan, where policy is still relatively easy, real rates are negative and shareholder-friendly reforms are taking root.

Bottom line

U.S. earnings are stagnating. Market expectations for a pickup in margins over the next year look rosy as worker shortages keep pressure on wages. We’re keeping a close eye on the labor market as a result and stay granular in DM stocks.

Market backdrop

U.S. stocks moved sideways below the 16-month high hit in July, with tech stocks underperforming after their sharp gains this year. Ten-year Treasury yields surged back near 15-year highs after volatile trading, partly due to a weak bond auction. The July CPI showed inflation cooling more. We see inflation on a rollercoaster ride ahead (see above). Market pricing of long-term inflation has diverged from shorter-term pricing, suggesting that markets see inflation pressures persisting longer term.

We’re watching GDP and inflation data across DMs this week. Inflation has returned in Japan but not as much as other major economies. The Bank of Japan (BOJ) is still unsure if higher wages are sustainable and can keep inflation around its target. Yet the BOJ loosened its yield cap again in July. We see that pulling local and global bond yields higher.

Week ahead

The chart shows that U.S. equities are the best performing asset year-to-date among a selected group of assets, while the U.S. dollar index is the worst.

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of Aug. 10, 2023. Notes: The two ends of the bars show the lowest and highest returns at any point in the last 12-months, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.

Aug. 15

Japan GDP; China retail sales

Aug. 16

Euro area flash GDP; UK inflation

Aug. 18

Japan inflation

Read our past weekly market commentaries here.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, August 2023

Asset		Tactical view	Commentary
Equities	Developed market		We are overweight equities in our strategic views as we estimate the overall return of stocks will be greater than fixed-income assets over the coming decade. Valuations on a long horizon do not appear stretched. Tactically, we’re underweight DM stocks as central banks’ rate hikes cause financial cracks and economic damage. Corporate earnings expectations have yet to fully reflect even a modest recession.
	Emerging market		Strategically, we are neutral as we don’t see significant earnings growth or higher compensation for risk. We are overweight tactically on brighter growth trends in EM over DM, still appealing valuations and EM rate cycles nearing their peaks.
Developed market government bonds	Nominal		Higher-for-longer policy rates have bolstered the case for short-dated government debt in portfolios on both tactical and strategic horizons. We stay underweight nominal long-dated government bonds on both horizons as we expect investors to demand more compensation for the risk of holding them. Tactically, we are neutral on euro area and UK long-term bonds because higher yields better reflect our view.
	Inflation-linked		Our strategic views are maximum overweight DM inflation-linked bonds where we see higher inflation persisting – but we have trimmed our tactical view to neutral on current market pricing in the euro area.
Public credit and emerging market debt	Investment grade		We are neutral investment grade credit due to tightening credit and financial conditions but see it playing an important income role in portfolios on both horizons.
	High yield		Strategically, we are neutral high yield as we see the asset class as more vulnerable to recession risks. We’re tactically underweight. Spreads don’t fully compensate for slower growth and tighter credit conditions we expect.
	EM debt		Strategically, we're neutral and see more attractive income opportunities elsewhere. Tactically, we’re overweight local-currency EM debt. We see it as more resilient with EM central banks closer to cutting rates than DM counterparts.
Private markets	Income	-	We are strategically overweight private markets income. For investors with a long-term view, we see opportunities in private credit as private lenders help fill a void left by a bank pullback.
	Growth	-	Even in our underweight to growth private markets, we see areas like infrastructure equity as a relative bright spot.

Note: Views are from a U.S. dollar perspective, August 2023. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, August 2023

Asset	Tactical view	Commentary
Equities
United States		We are underweight the broad market – still our largest portfolio allocation. We don’t think earnings expectations reflect the macro damage we expect. We recognize momentum is strong near-term.
Europe		We are underweight. We see the European Central Bank holding policy tight in a slowdown, and the support to growth from lower energy prices is fading.
U.K.		We are neutral. We find that attractive valuations better reflect the weak growth outlook and the Bank of England’s sharp rate hikes to deal with sticky inflation.
Japan		We are neutral. Bank of Japan policy is still easy, shareholder-friendly reforms are taking root and negative real rates support equities.
Pacific ex-Japan		We are neutral. China’s restart is losing steam and we don’t see valuations compelling enough to turn overweight.
DM AI mega force		We are overweight. We see a multi-country and multi-sector AI-centered investment cycle unfolding set to support revenues and margins.
Emerging markets		We are overweight. We see brighter relative growth trends in EM over DM, valuations remain appealing and EM rates cycles are nearing peaks.
China		China’s economic restart is fading, yet low inflation creates space for more policy easing. The bar for upside surprises is low given current valuations. Structural challenges like geopolitical risks persist.
Fixed income
Short U.S. Treasuries		We are overweight. We prefer short-term government bonds for income as interest rates stay higher for longer.
Long U.S. Treasuries		We are underweight. We see long-term yields moving up further as investors demand greater term premium.
U.S. inflation-linked bonds		We are overweight and prefer the U.S. over the euro area. We see market pricing underestimating sticky inflation.
Euro area inflation-linked bonds		We prefer the U.S. over the euro area. Markets are pricing higher inflation than in the U.S., even as the European Central Bank is set to hold policy tight, in our view.
Euro area government bonds		We are neutral. Market pricing better reflects rates staying higher for longer. We see risk of wider peripheral bond spreads due to tighter financial conditions.
UK Gilts		We are neutral. We find gilt yields better reflect our expectations for the macro outlook and Bank of England policy.
Japan government bonds		We are underweight. We see upside risks to yields from the Bank of Japan winding down its ultra-loose policy.
China government bonds		We are neutral. Bonds are supported by looser policy. Yet we find yields more attractive in short-term DM paper.
Global investment grade credit		We are neutral on tighter credit and financial conditions. We prefer Europe’s more attractive valuations over the U.S.
U.S. agency MBS		We’re overweight. We see agency MBS as a high-quality exposure within diversified bond allocations.
Global high yield		We are underweight. Spreads do not fully compensate for slower growth and tighter credit conditions we anticipate.
Asia credit		We are neutral. We don’t find valuations compelling enough to turn more positive.
Emerging market - hard currency		We are overweight. We prefer emerging hard currency debt due to higher yields. It is also cushioned from weakening local currencies as EM central banks start to cut policy rates.
Emerging market - local currency		We are neutral. Yields have fallen closer to U.S. Treasury yields. Plus, central bank rate cuts could put downward pressure on EM currencies, dragging on potential returns.

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Note: Views are from a U.S. dollar perspective. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.

Euro-denominated tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, August 2023

Asset	Tactical view	Commentary
Equities
Europe ex UK		We are underweight. We see the European Central Bank holding policy tight in a slowdown and the support to growth from lower energy prices is fading.
Germany		We are underweight. Valuations are moderately supportive relative to peers, but we see earnings under pressure from higher interest rates, slower global growth and medium-term uncertainty on energy supply. Longer term, we think the low-carbon transition may bring opportunities.
France		We are underweight. Relatively richer valuations and a potential drag to earnings from weaker consumption amid higher interest rates offset the positive impact from past productivity enhancing reforms and favorable energy mix.
Italy		We are underweight. The economy’s relatively weak credit fundamentals amid global tightening financial conditions keep us cautious even though valuations and earnings revision trends look attractive versus peers.
Spain		We are underweight. Valuations and earnings momentum are supportive relative to peers, but the uncertain outcome of Spanish elections is a temporary headwind.
Netherlands		We are underweight. The Dutch stock markets' tilt to technology and semiconductors, a key beneficiary of higher demand for AI, is offset by relatively less favorable valuations and earnings momentum than European peers.
Switzerland		We are overweight. We hold a relative preference. The index’s high weights to defensive sectors like health care and non-discretionary consumer goods provide a cushion amid heightened global macro uncertainty. Valuations remain high versus peers and a strong currency is a drag on export competitiveness..
UK		We are underweight. The Bank of England is hiking sharply to deal with sticky inflation. While equities price in more downside risk, we await policy clarity.
Fixed income
Euro area government bonds		We are neutral. Market pricing better reflects rates staying higher for longer. We see risk of wider peripheral bond spreads due to tighter financial conditions.
German bunds		We are neutral. Market pricing better reflects policy rates staying higher for longer. We prefer short-term government paper for income.
French OATs		We are neutral. Valuations look moderately compelling compared to peripheral bonds, with French spreads to German bonds hovering above historical averages. Elevated French public debt and a slower pace of structural reforms remain headwinds.
Italian BTPs		We are neutral. The spread over German Bunds looks tight amid deteriorating macro and restrictive ECB policy. Yet domestic factors remain supportive, namely a more balanced current account and prudent fiscal stance. We see income helping to compensate for the slightly wider spreads we expect.
UK gilts		We are neutral. We find that attractive valuations better reflect the weak growth outlook and the Bank of England’s sharp rate hikes to deal with sticky inflation.
Swiss government bonds		We are neutral. We don’t see the SNB hiking rates as much as the ECB given relatively subdued inflation and a strong currency. Further upward pressure on yields appears limited given global macro uncertainty.
European inflation-linked bonds		We are underweight. We prefer the U.S. over the euro area. Markets are pricing higher inflation than in the U.S., even as the European Central Bank is set to hold policy tight, in our view.
European investment grade credit		We are modestly overweight European investment-grade credit for decent income. We prefer European investment grade over the U.S. given more attractive valuations. We monitor tighter credit and financial conditions.
European high yield		We are neutral. We find the income potential attractive yet prefer up-in-quality credit exposures amid a worsening macro backdrop.

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Note: Views are from a euro perspective, August 2023. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.