Week Ahead: earnings disappointment, the declining oil price and the dollar is king once again

Last week was a pivotal one for financial markets, when it seemed that investors finally took stock of the higher for longer narrative that is coming from the major central banks and weighed on risk sentiment.  The S&P 500 had its second straight decline, and the end of earnings season means that we can confirm 2022 delivered subpar earnings in Q4, and the number of positive earnings surprises combined with the magnitude of those surprises were both below 5 and 10-year averages. Along with Fed minutes, a Chinese rate decision and the first reading of February PMIs could keep investors busy.

Earnings expectations are weighing on stock prices  

Looking at Q4 earnings season first, all eyes are on forward guidance and what analysts think will happen in the future. According to FactSet, analysts expect earnings declines of 5.4% and 3.4% respectively in Q1 and Q2 this year for the S&P 500, before earnings start to pick up again in the second half of the year. For 2023, earnings growth is expected to be 2.3%. This is unimpressive when compared to the risk-free yield that is on offer from buying Treasuries. The yield on the 2-year is currently 4.63%, which is one of the highest levels since 2007. The low yield era is behind us, and this is problematic for stocks. Thus, here at Minerva we argue that the stock market sell off is not only about the Fed failing to pivot, but also because of expectations of an earnings recession. Add in concerns that stocks remain too over-valued, and we could be set up for another poor week on the stock market. Right now, the 12-month forward P/E ratio for the S&P 500 is 18, which is below the 5-year average of 18.5, but above the 10-year average of 17.2, according to FactSet. It is also above the 12-month forward P/E ratio recorded at the end of December 2022, which stood at 16.1. If stocks are deemed expensive and negative earnings growth is also expected in the future, then this is a toxic mix for stock markets and this is the biggest reason why we think stock markets are likely to struggle again this week, regardless of the backward-looking Fed minutes.

The dollar makes a comeback

There has been an enormous re-pricing in the Fed Funds Futures market in recent days. Less than a month ago, the market was expecting rates to peak below 5%, and for a series of cuts to take place before the end of the year to the tune of approx. 80 basis points. Now US rates are expected to peak at 5.25-5.5% by July 2023, and the bulk of the market believe that rates will now only be cut once by year end to 5-5.25%. A mere month ago, rates were expected to be cut back to 4.25-4.5% by year end, according to the CME’s Fedwatch tool. This is a massive re-pricing and one that is helping to fuel dollar strength. The dollar index is back with aplomb, after a weak start to the year. EUR/USD is trading below $1.07, it had been attempting to breach $1.10 at the start of this month. Meanwhile, GBP/USD is also trending lower, and is just managing to hang on to the $1.20 handle at the open of a new week. This is mostly down to interest rate differentials, with expectations growing that the BOE will cut rates before the Federal Reserve, after BOE Chief Economist Huw Pill suggested that if the UK economy continues to weaken then rate cuts could be on the cards.

Data watch for this week

While all eyes will be on the Federal Reserve minutes that are released on Wednesday, it is worth watching the early PMI reports that are released on Tuesday. If we see further declines in these surveys, then it could ease rate hike expectations, especially in the US, and give markets a breather from selling pressure. It is worth noting that improvements are expected for the survey results in the UK and Europe, albeit from a weak level. We will also be watching the Chinese central bank, who will announce their policy decision early on Monday morning. The main short term lending rate and the 5-year Loan Prime Rate, which are China’s benchmark interest rates, are expected to remain unchanged at this week’s meeting, after cuts in January. Analysts that specialise in China and who we follow here at Minerva, think that a consecutive cut would squeeze bank margins by too much, which could cause problems down the line. And while Beijing is calling 2023 the year of growth, the PBOC may take a more cautious approach. As ever, when it comes to the PBOC, there could surprises, so expect the unexpected, even if we think that it is more likely that they remain on hold. USD/CNY has started the week higher and has steadily been rising since reaching a low of 6.7 in early January. It is still some way off the November peak at 7.3, and it would take more broad-based dollar strength, and a significant bout of risk aversion, to reach this high level in the near term.

The oil price offers hope that core inflation could have peaked

Overall, this week is likely to be another rough one for stocks, however, we would argue that growth continues to outperform value right now, and this may continue, believe it or not, because of the oil price. This may sound counter-intuitive, but the sell off in oil helps growth stocks in two ways: 1, it ways on energy stocks, 2, its impact on future inflation and the potential path for interest rates. Brent crude is trading around $83 per barrel, which is below the level reached before Russia invaded Ukraine. This is good news for central banks as they try to fight inflation, and if oil continues to fall, then it could help to tame core inflation also, as energy prices are also a big part of service-price inflation. However, it is worth noting that core prices tend to fall at a slower rate than headline prices, and this can be bad news in the short term for impatient markets. In our view, while the mood on the street is pessimistic for now, we are still hopeful that inflation will fall sharply this year, with declines also expected in core prices, after the recent gentle upswing. While we think that there could be more downside to work through when it comes to stock prices, we remain hopeful of a rally once the price is right.