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U.S. corporate earnings have stagnated over the past year even as second-quarter 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.
U.S. earnings have stagnated over the past year as pandemic-driven spending shifts normalized, squeezing profit margins. Margins ticked up in the second quarter, 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 second-quarter 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 four 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 second-quarter wage data confirmed spending is normalizing. And that means profit margins are starting to normalize as well, even with the slight improvement in the second quarter.
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. Read more in our blogs here and here.
Our second takeaway from second-quarter 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. Second-quarter 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.
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.
View the full report from BlackRock’s August 14, 2023, Weekly Market Commentary, by Jean Boivin, Head – BlackRock Investment Institute, Wei Li, Global Chief Investment Strategist, BlackRock Investment Institute, Alex Brazier, and Carolina Martinez Arevalo, Portfolio Strategist – BlackRock Investment Institute
Alex Brazier is Managing Director, Deputy Head of the Blackrock Investment Institute at BlackRock Inc.
Disclaimer
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.
© 2023 BlackRock Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. This article first appeared August 14, 2023, on the BlackRock website. Used with permission.
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