The Eurozone vs the US, as Microsoft beats on earnings

It’s not often that the Eurozone economy outshines the US, but it happened on Tuesday. The latest PMI data for January showed that European activity is expanding, while the US remains in contraction territory. The S&P Global Composite PMI for the US disappointed expectations and came in at 46.6, while the equivalent survey in the Eurozone rose to 50.2, with the service sector survey jumping to 50.7. This is a decent performance considering there had been much gloomy talk about the Eurozone in recent months. However, a warm winter, excellent forward planning when it came to gas storage and falling inflation is working its magic on the continent. Sadly, the UK is once more looking like an outlier for all the wrong reasons. It’s composite PMI slid further in January to 47.8, suggesting that it will take longer for the economic malaise to lift from our shores. The result of this data was a further extension in the EUR rally, it was one of the best performers in G10 FX space on Tuesday, and EUR/USD broke above $1.0850, and is currently trading at its highest level since April 2022.

Europe starts to outpace its trans-Atlantic rival

The outlook has brightened for the Eurozone, and the divergence between the European outlook and the outlook for the US sets the euro up for further increases in our view. The Eurozone economy is stabilising, and is likely to avoid a recession, if this data is anything to go by. What is interesting, is that in recent months the survey data has underestimated economic performance, thus the Eurozone economy could be stronger than what the PMI surveys suggest. Added to this, divergent monetary policy paths for the Federal Reserve and the ECB could also bolster the position of the euro this year. Right now, the market is looking for two more 25 bp rate hikes from the Fed, before rates start to fall from mid-year. Thus, the market expects the Fed to be close to the peak of its rate-hiking cycle, just as the ECB is getting started. Since the ECB only started hiking rates in July last year, well after the BOE and the Fed, this is to be expected. However, the strength and resilience of the Eurozone economy, could keep the ECB hiking for longer. On Tuesday, ECB policy member Gediminas Simkus, said that the ECB should continue to hike rates by 50 bps this year amid growing wage pressures. He also suggested that reaching peak ECB rates before the summer was unlikely due to the stubbornness of core inflation. This is fighting talk, could the euro go the way of the dollar last year? If yes, it would be good news for headline inflation, as it would weigh on the price of energy imports into the currency bloc.

FX: it’s all about the euro

From a EUR/USD perspective, while in the short term we think that this pair is looking overbought, and could hit some resistance around $1.0950, overall, we think that this will prove temporary and that the march higher above $1.10 in EUR/USD will continue. There is also the potential in Q1 for this pair to climb back towards the February 2022 highs at $1.1450. Added to this, there is growing evidence that the US economy is weakening, and that the Fed will reduce the size of rate hikes yet again at next week’s Fed meeting to the more traditional 25bp hike, as suggested in a Wall Street Journal Article at the weekend. US home sales fell 18% in 2022, retail sales fell 1.1% in December, even the labour market is showing signs of weakness, for example, a slower pace of hiring temporary workers in January could be a precursor to lower hiring overall in the coming months. The US Q4 GDP report will be released on Thursday, which is expected to show that Q4 YoY GDP rose by 2.8%, a slowdown from the 3.2% recorded in Q3. Added to this, as mentioned above, the PMI survey suggests that the US economy started 2023 on a disappointing note.

Earnings season and profit margin deceleration

Fears about the US economy is starting to weigh on stocks, with lacklustre returns from global indices at the start of this week. Both the S&P 500 and the Nasdaq fell on Tuesday. This is typical peak rate behaviour – the top of the cycle can hurt equities as corporate earnings take a hit from a weakened economy. The latest data from FactSet reports that the S&P 500 has reported a lower net profit margin for the sixth straight quarter. This is concerning, particularly if companies are hoarding labour, which is one explanation of why the unemployment rate in the US is so low. If labour is being hoarded, largely because it is so hard to find staff with the right skills in the post-covid environment, then this could also weigh on firms’ profit margins in the future. If there is one thing that a stock investor does not like, it’s falling profit margins. Thus, if you want the best chance to back a winning stock this year, follow the profits. FactSet shows that energy and industrials are the only sectors that are beating their 5-year averages when it comes to profit margins. Thus, as stock markets digest this news, it could press pause on the recent rally in equities that helped to lift some of the January gloom.

Will the ECB tighten too much?

Traders should remember two things over the medium term, even if the euro continues to rally in the coming weeks. Firstly, the Eurozone economic data is likely to go the way of the US, especially if the ECB hikes rates for a protracted period this year. Rates in Europe have further to rise at the same time as the US is nearing the end of its tightening cycle. Thus, eventually US stocks will look more attractive than their Eurozone counterparts. However, we may have to wait some weeks for that to happen, especially as we look towards tech earnings season in the US this week and next.

Microsoft earnings surprise

One sector that is not hoarding labour is the tech sector. The major tech companies excluding Apple have all announced five figure layoffs in recent weeks. On Tuesday Microsoft released Q4 earnings, while the other major tech firms including Apple, Amazon and Alphabet all release earnings at the start of February. Even if you don’t care for tech stocks, you need to care about their earnings, because they have a heavy weighting in the S&P 500. Due to this, their Q4 earnings are super important, and a disappointing earnings season could lead to a broader market sell off. The bar is low for Q4 tech earnings. Analysts expect revenue growth of 2%, including a 1% decline in revenue growth for Apple, along with profit growth to decline by 26% compared to a year earlier. Tighter regulations, tight monetary policy that reduces the value of future cash flows and a recession on the horizon where corporate and consumer IT spend could be constrained, are all hurting sentiment towards the tech sector. It is worth noting that the Nasdaq is up some 10% so far this year, however, investors want to know if this rally is sustainable, and they will be looking for clues from this earnings season. The news from Microsoft is good. It beat analyst expectations for earnings: up $2.32 per share, vs. $2.29 per share that was expected. Revenue was roughly in-line at $52.75 billion. Net income fell, after the company took a $1.2bn hit related to shrinking its workforce by 10,000. Revenue from its Intelligent business unit rose 18%, while revenue from its Azure Cloud business rose 31%, in line with analyst estimates. Personal computing including gaming, slid some 19%, which was widely expected. The market likes the tone of these results, as they suggest that corporates are not yet cutting IT spend by as much as feared, and the company’s all-important cloud unit is still growing at a decent 30% + annual rate, we expect Microsoft execs to be happy with this performance, and also breathing a sigh of relief that corporates haven’t been more brutal in cutting cloud spend, and in hoping for more relief in the coming months especially if the Fed does reach peak rates soon.

Microsoft’s stock rose more than 4% in after-hours trading on Tuesday, the question now is, can the rest of the tech sector beat low expectations for Q4 earnings season? Microsoft’s experience suggests that they can, even if Apple is an outlier due to Chinese lockdowns.