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Key themes to watch during Q3 earnings season

The supply and demand mismatch has driven inflation higher. Is it enough to derail the strong earnings momentum?


Our Top Market Takeaways for October 15, 2021.

Markets in a minute

Inflation on my mind

Stocks just had their best day since March
. It was starting to seem like investors had cabin fever, given it’s been 29 trading days since the S&P 500’s last new record close – the longest such streak since autumn of 2020. But Thursday’s +1.7% S&P 500 rally delivered gains of +1% or more for all 11 sectors, and brought the index within 4% of last month’s all-time high. The perk-up in performance is mostly thanks to strong Q3 earnings results from many of the season’s early reporters, and the positive momentum continued with further gains for the S&P 500 on Friday morning.

Before we dig into our thoughts on earnings, we would be remiss not to address the most notable data release of the week: September inflation figures. The Consumer Price Index (CPI) print came in close to what was expected: Headline CPI was +5.4% year-over-year, and Core CPI was +4.0% year-over-year. From August to September, core rose only 0.2%—more in-line with “normal” versus the eye-popping prints we saw over the summer.

The notable thing about this month’s report is that it showed the drivers of inflation are starting to broaden out. Car prices (+1.3% month-over-month) are still being squeezed by the semiconductor shortage, while other reopening pressures in areas such as transportation services (-0.5%) and hotels (-0.6%) actually eased. But other, stickier areas such as owners’ equivalent rent (+0.4%) picked up in September by more than what we saw at any point in the last cycle.

That might be read as a sign that the tradeoff between “transitory” inflation pressures and more persistent ones is happening faster than expected, and parts of the market have reacted accordingly. The two-year Treasury yield, for example, headed into Friday at 0.36%, up +6 basis points (bps) versus a week ago, and +14 bps versus a month ago. Ten-year yields have dropped -10 bps to 1.51% since last Friday. The market-priced fed funds rate for the end of 2022 has crept higher, and is signaling at least one rate hike next year.

At this time, we’re not changing our base case assumption that the first hike won’t come until 2023. But we think this cycle will be marked by stronger growth and stronger inflation than the last, and the tail risk of the Federal Reserve hiking sooner is growing. Even so, our Equity Strategists think there’s still plenty of room for rates to rise before they would challenge our optimistic outlook for stocks. That outlook is based on our belief in the strength of earnings momentum, and the third-quarter earnings season that kicked off this week will offer a gut check on that.


Three themes to watch during the 3Q earnings season

It seems likely that the S&P 500 reached peak earnings growth at +89% year-over-year this cycle in the spring quarter (Q2). Nevertheless, we still expect above-average earnings growth and positive revisions as results roll out for Q3 in the coming weeks. In the run-up to the reports, 60% of U.S. companies have issued positive EPS guidance, which is well above the five-year average of 33%. Given that, we have a broadly positive view heading into the Q3 reporting season.

But with that positive stance comes an awareness of several headwinds that companies have had to navigate over the last few months. In particular, there are three key topics we want to hear more about:

1) Supply

Supply shortages have significantly impacted industries globally, and so far this has led to a 1% drop in aggregated Q3 estimates for the S&P 500. Shortages range from labor to commodities, to semiconductors, so various inputs are not as readily available right now as they used to be. This is weighing on businesses that are unable to produce sufficient amounts of goods to meet demand.

We have already heard from a few companies about the negative impact on their businesses. Most notably, reports suggest that Apple will produce 10 million fewer iPhones this year because Broadcom and Texas Instruments cannot supply enough components. The market, though, seems to have been anticipating these kinds of issues, so they’re likely baked into current expectations.

Another example: The truck producer Paccar announced that semiconductor chip shortages reduced deliveries of trucks over the last months. As such, it will be crucial for companies to reassure investors that they are able to overcome the supply chain disruptions during their earnings calls this quarter—companies such as Levi Strauss handled this deftly, reporting strong results earlier this month that beat expectations thanks to the firm’s diversified supply chain across countries.

2) Demand

While the supply side has come under pressure amid shortages and other weather- and shipping-related disruptions, the demand backdrop has remained very supportive. Some estimates suggest that strong demand has accounted for two-thirds of the rise in global manufacturing supplier delays, which is ultimately positive for the growth of companies’ order books.

For example, ASM International, a semiconductor equipment manufacturer, is seeing very strong Q3 order intake. What this tells us is that while semis are in scarce supply at the moment, semiconductor manufacturers are investing in new capacity, ordering new equipment and opening new sites to meet the rising demand for chips in the near future. This lends to the argument that supply constraints should be temporary. 

We’re getting upbeat signals outside of the semiconductor segment, too, because consumers remain in good shape and continue to spend the savings they accumulated during the pandemic. Nike, for example, reported a spike in demand in North America, amplified by the back-to-school season and the return to athletics. Earlier this week, the luxury group LVMH reported better-than-expected organic sales growth.

3) Inflation

Constrained supply that meets strong demand ultimately translates into rising prices, sparking the pick-up in inflation over the last few months. On top of that, we have seen wages increase over the last year as well.

Companies are feeling this and are responding to it. We recently heard from Pepsi’s CFO that the company will be raising prices to offset higher commodity, transport and supply chain costs. This is key for earnings season: Investors want to see companies pass on those higher costs to consumers, but they can only do so if they have sufficient pricing power. Ultimately, higher wages and input prices could put pressure on companies’ profit margins in the coming quarters, but we believe businesses are in a position where they can defend their margins by increasing their prices. Recent business survey data confirms this view. As a result, we estimate that margins will remain flattish.

As for the investment implications?

Given the several headwinds that companies are facing at the moment, we believe stock selection into the quarter is key. We think the market will reward those companies with strong pricing power and the ability to reiterate/increase their full-year guidance. We think that makes for a fertile hunting ground for stock pickers, especially those actively managing portfolios of companies levered to the trends that will define this economic cycle.

All market and economic data as of October 2021 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.


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All companies referenced are shown for illustrative purposes only, and are not intended as a recommendation or endorsement by J.P. Morgan in this context.

All market and economic data as of October 2021 and sourced from Bloomberg and FactSet unless otherwise stated.

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