Markets are being shaped by disparate trends from falling energy prices to rising interest rates. During first-quarter earnings season, company reports indicated that these crosscurrents are intensifying business challenges—and making it harder for investors to find resilient sources of growth.
Investors who sought clarity on the economy and earnings in recent earnings reports were left unsatisfied. It was little comfort that around three-quarters of companies globally beat earnings expectations by mid-month, with reporting season nearly complete. The earnings bar was set low, as many companies had already reduced expectations in anticipation of a recession. But most companies didn’t raise full-year estimates amid pervasive concerns about the outlook.
Companies Face Conflicting Trends
While the long-expected recession hasn’t arrived, macroeconomic conditions are murky. High inflation is stickier than expected, short-term interest rates continue to rise and banking sector turmoil is adding instability. Yet energy prices have fallen, supply chain disruptions are easing and China’s economy is reopening. Some of these crosswinds are butting against each other, so investors must find companies that are navigating them with skill.
Earnings growth trends reflect the muddy environment. In both global and US markets, six sectors contributed to earnings growth while five detracted, leading to overall flattish growth of +0.3% for the MSCI World and –0.2% for S&P 500 (Display). The consumer discretionary sector was a major contributor to earnings growth, despite mounting pressure on US consumer spending from higher rates and recession concerns. Information technology and healthcare have weighed on earnings growth, even as some industry segments remain robust. And despite recent bank failures, financials added the most to earnings growth, as lenders broadly tend to benefit in high interest-rate environments.
Business dynamics also differ within sectors and among individual companies. So how can stock pickers identify companies that can deliver growth in such tricky conditions?
US Consumer Feels the Heat
Consumer spending illustrates the conundrum. In the US, retail giant Costco reported sales in March were down 1.1% from the same month last year. UPS reported weakening US shipping volumes. Visa and Mastercard volumes suggest that US spending growth decelerated from about 12% in January to 7% toward quarter-end.
At the same time, consumer giant Amazon.com exceeded expectations. Consumer staples companies also generally demonstrated strong pricing power.
US consumers have tough choices to make. Even as lower energy prices provide some relief, higher interest rates make mortgages more expensive and inflation is eroding spending power. In this environment, people are unlikely to pull back spending on essentials—from coffee to contact lenses. But nonessential discretionary spending is under pressure. Investors must distinguish between consumer companies that have a critical mass of indispensable products, which should continue to enjoy demand, versus others whose less essential product lines could get squeezed as consumers tighten their belts. This requires a rigorous analysis of products, competition and pricing power.
Outside the US, European consumers also face tough circumstances. But in China, consumers are vigorously shopping as the economic reopening following prolonged COVID-19 lockdowns continues. This has provided a boost to select global consumer brands, including luxury goods companies such as LVMH Moët Hennessy Louis Vuitton and L’Oréal. Global companies with significant revenue from Chinese consumers could enjoy support to offset weakness in US and European spending.
Technology: Sluggish Spending vs. AI Acceleration
The technology sector is also a mixed bag. IT spending on PCs and communication services was weak. CDW, a US technology reseller to small and midsize businesses, projected a significant decline in US technology spending from its outlook earlier this year.
Spending on the cloud is slowing, but absolute growth was better than expected, with solid positive numbers from the largest players. Amazon’s AWS reported first-quarter growth of 16%, while Microsoft’s cloud business Azure expects growth to slow from 31% in the first quarter to a still-healthy 26% in the second quarter.
Meanwhile, the AI revolution, driven by ChatGPT’s rapid adoption, has lifted hopes in the sector. Microsoft executives say the pace of AI innovation is unprecedented. In our view, accelerated adoption of AI will drive a new wave of tech spending as companies seek to unlock efficiencies. Companies in diverse parts of the sector, including Cap Gemini (IT services), ASML (semiconductors) and Cadence Design (software) could play an integral role in enabling the broader adoption of AI.
Healthcare: Back to the Doctor
Healthcare stocks disappointed in the first quarter. But beneath the surface, positive trends are surfacing, as post-COVID demand picks up. People are going back to see doctors for regular checkups and to hospitals for elective surgeries. Earnings reports from US healthcare groups show that the median rate of hospital admission growth doubled to 3% in the first quarter, compared with the fourth-quarter of 2022 and declines in previous quarters. Trends like these have played out in the results of companies such as Abbott Laboratories, Johnson & Johnson and Intuitive Surgical.
People will continue to spend on healthcare products and services, even in a tighter macro environment, in our view. And healthcare companies are generally well capitalized. As a result, we believe select healthcare stocks offer defensive features for tougher conditions.
How to Develop Conviction
Earnings season demonstrated just how tough the environment is for companies and investors. Portfolio managers can’t simply anchor a strategy around a tailwind for a sector today. But some companies are better placed than others to rise above the pack.
Look for companies with clear secular growth drivers that are unlikely to be derailed by macroeconomic uncertainty. Pricing power will continue to be a key differentiator as inflation remains high; and if inflation begins to subside we need to ensure that even companies with pricing power have strong underlying volume growth. Companies with products that are must-haves for consumers—even in a tough economy—will be advantaged. Finally, companies that can cut costs and have low debt/healthy balance sheets will be better placed to navigate choppy financial waters.
These guidelines provide investors with a path to developing conviction in defensive growth companies that can deliver solid business results—and investment returns—in the face of adversity. They’re not easy to find, but investors who adhere to clear parameters for pinpointing real growth will be able to create sturdy portfolios that can power through the gusts without fear.
- James T. Tierney, Jr.
- Chief Investment Officer—Concentrated US Growth
- Dev Chakrabarti
- SVP/Co-CIO, Concentrated Equities - Global—Concentrated Equities-Global-ABL
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