Too calm, too quickly? Too calm, too quickly? Too calm, too quickly?

Equity outlook, sticky inflation, and banks earnings preview

Peter Garnry

Chief Investment Strategist

Summary:  The expected real rate return for equities looks more attractive than that offered in global bonds and as such investors should still be allocating to equities. The underlying momentum in the economy and cash flows from companies suggest at this point that it is only a recession that can derail the equity market. In today's equity update we also reflect on yesterday's US inflation report and how the fragmentation game and labour shortage will continue to underpin inflation dynamics. Lastly, we go through the expectations for tomorrow's banking earnings from JPMorgan Chase, Wells Fargo, and Citigroup.

Only a recession can derail equities

Global equities have overcome the shock from higher interest rates and the low level of debt in the corporate sector means that the equity market will do fine during a refinance of debt at higher interest rates. Nominal growth remains strong post the pandemic and with the Chinese reopening gathering pace a recession might not happen in 2023, or if the economy slows down it may be a shallow and short-lived contraction. Total shareholder payout (dividends and buybacks) is at an all-time high for the MSCI ACWI Index (developed and emerging markets) with the total payout yield currently at 3.5%.

We add long-term expectations of 2.2% global real GDP growth then global equities have a long-term real rate return expectation of 5.7% annualised. For comparison the benchmark on global bonds offer a nominal yield-to-worst yield of 3.5% which after subtracting the 10-year inflation expectation of 2.5% provides you with a 1% expected real rate return. If we adjust for expected volatility the expected real sharpe ratio is a bit more attractive for equities than bonds. Historically it is only recessions that ends the uptrend in equities and this time is no different.

The fragmentation game leads to sticky inflation

The US March CPI report yesterday gave yet again the signal that core inflation remains stubbornly high with the US services CPI excluding energy at 6.6% annualised rate using the average m/m figures for the past six months. This figure will continue to come down but as we have said so many times before the question is where inflation settles. We remain in the camp that inflation will remain more sticky than the current pricing and that core services inflation rate in the US could settle around 4% or above.

The fragmentation game that we described in our Q2 Outlook is essentially a roadmap for what to expect as regions fragment across the three pillars of technology (computing power), energy, and defense. Fragmentation means higher costs because it is the opposite dynamic of globalisation and ever expanding supply sides and with the labour force stagnating, or even declining in some countries, there will continue to be pressure on wage costs which at this point must be the single biggest risk and concern for companies as that component is the most important going forward for operating margins.

Earnings preview: What will banks tell investors tomorrow?

The Q1 earnings season is on with Delta Air Lines reporting Q1 results that disappointed a bit against estimates but Q2 guidance on EPS at $2-2.25 was well above estimates of $1.61 suggesting airliners are seeing no slowdown in pricing or demand despite fears of that due to high inflation hitting consumers. But tomorrow is when the earnings show really starts with Q1 earnings (reporting time in GMT) from JPMorgan Chase (11:00) , Wells Fargo (11:00), and Citigroup (12:00). Analysts expect Q1 EPS (y/y growth) of $1.13 (+28%) for Wells Fargo, $1.67 (-31%) for Citigroup, and $3.38 (+21%) for JPMorgan Chase.

The trade in banking stocks was driven by rising net interest margins with regional banks seeing the biggest tailwinds, but with the recent banking crisis funding costs are on the rise for banks and the trade has died for now. JPMorgan CEO Jamie Dimon wrote in his recent shareholder letter that the banking crisis is not over yet and it is still a bit unclear how the crisis has impacted different banks. One thing do know from Federal Reserve is that deposits overall in the US banking system has continued to decline with the latest data point from 29 March at $17.2bn down 5.3% from 13 April 2022.

We expect major US banks to have benefitted from the crisis on the funding side as their size and SIFI label have provided them with safe-haven inflows of deposits while smaller banks are likely to show pressure on the funding side. We also expect the outlook to be mixed with US banks highlighting the resiliency of households and corporates but also acknowledging rising funding costs and tighter lending standards leading to lower loan growth and earnings growth over the next year. The 12-month forward EPS growth in the S&P 500 banks index is -0.6%

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