Monthly Outlook: Watch Out for Potential Downward Adjustments to US Stock Earnings

Monthly Outlook 202211 Equity Research·Strategy Research·Monthly Outlook [Table_Main] Watch Out for Potential Downward Adjustments to US Stock Earnings Report Thesis: ◼ The recent rally we have observed in the US stock market is largely based on signs of inflation peaking out and a potential shift in investors’ sentiment. On the one hand, with the lower-than-expected inflation data in October 2022, investors are generally looking at the Fed to signal that policy rates will peak in May 2023, and hence help repair stock valuations that have been battered since the end of 2020. Moreover, market sentiment is expected to bottom out. Historically, stock market sentiment bottoming out in 1990, 2003, 2009 and 2020 were signs of capitulation and associated with high stock returns in the subsequent 6 months. Report Abstract: ◼ Outlook for earnings and valuation of US stocks. For the earnings side, we have just started to see the compression of margins as the suppression of consumption by the high inflation begins to kick in. With consumer demand gradually digested after the end of COVID lockdown, the increase of inventories, the decline of household income suggest that corporate margins still have plenty of room to deteriorate. The market is now pricing in the Fed’s dovish pivot but ignoring the fact that the dovish stance is accompanied by recession. Therefore, falling corporate earnings resulted from a hard landing situation has yet to be priced in. According to FactSet earnings estimates, analysts expect S&P 500 net profit margins to be higher than Q3 2022 for the rest of 2022 and the first half of 2023, but this estimation is difficult to achieve given the current economic outlook. Therefore, we believe the risk of downward pressure on the share price from earnings revisions needs to be paid close attention to. ◼ In terms of valuation, we consider existing evidence in support of the assumption that the Fed will end its rate hikes in the first half of 2023 to be relatively weak. If the Fed does not take a dovish turn any time soon, the current stock price increase caused by expectation of a dovish policy stance will have to be repaired downwards. While valuations for US stocks have fallen, they still cannot be called cheap. In addition, although inflation appears to be moderated temporarily, core services inflation remains at its historical high on a yoy basis, mainly because rental costs have not fallen, and thus overall inflationary pressure has not dissipated. ◼ Finally, we think another significant risk is that market expectations are largely based on the assumption that the Fed will be able to deliver accurate and timely policy responses. However, the Fed has proved to be mistaken for multiple times over the past year in underestimating the degree of inflation persistence and in its slow response to stem inflationary momentum. Any imperfect policy measures could come with side effects and lead to market volatility. At the same time, as we argued in our October 2022 report, due to the shrinking Fed balance sheet and the decreasing short-term Treasury issuance, US market liquidity risks remain a concern for investors. ◼ Risks: Downward adjustments to US stock earnings could hurt stock prices; Inflation data could rebound, disappointing market expectations for monetary easing; Policy miscalculation by the Fed could worsen economic recession and hit both valuation and earnings. Research Analyst Shirui Ouyang (852) 3892 3120 ouyangshirui@dwzq.com.hk [Table_Report] Related reports 1. Embracing Risks and Opportunities 2022-04-11 2. The US Stock Market Has Not Fully Priced in Inflation Data and Interest Rate Hikes 2022-06-29 3. Fading Inflation and Growth: What Are the Signals Delivered by US Economic Indicators? 2022-07-20 4. Negative Interest Rate Era is Over, and Where is Europe Headed? 2022-08-09 5. Be Prepared for Further Aggressive Fed Rate Hikes 2022-09-16 6. Reduce risk exposure to European markets and beware of liquidity shortage in the US 2022-10-17 We would like to acknowledge the contribution and support provided by Hanruo Feng(冯涵若). [Table_Author] 28 November 2022 2 / 13 东吴证券（香港） 请务必阅读正文之后的免责声明部分 [Table_Yemei] Monthly Outlook Table of Contents 1. Expectation for dovish pivot and a shift in sentiment supported US stocks on the upside ......... 5 2. Risks for earnings and valuation of US stocks ................................................................................ 6 3. Risks Highlight ................................................................................................................................. 11 3 / 13 东吴证券（香港） 请务必阅读正文之后的免责声明部分 [Table_Yemei] Monthly Outlook Table of Figures Figure 1: The recent rally we