What I Care About This Week | 2022 Oct 10

drone shot of the ukrainian motherland monument
Photo by Mykola Kondrashev on Pexels.com

by Franklin J. Parker, CFA

The Summary

  • The Bottom Line. This week starts earnings season, which will be important, but not nearly as important as the ongoing economic data as interpreted through Federal Reserve’s actions. In sum, investors expect about 3% earnings growth for this quarter, and outlooks will be watched closely for signs that inflation is eating into profits and/or consumers have slowed their buying.

  • Major banks, Walgreens, and Delta Airlines report earnings this week. Investors are listening closely to calls with executives to hear their outlooks for the economy, inflation, and spending. In sum, earnings are expected to grow about 3% for the quarter, but that is not equally distributed. Energy, Industrials, and Consumer Discretionary sectors are expected to see the highest growth this quarter, whereas Telecom, Financials, and Materials are expected to see the biggest drop.

    We also see data on inflation, retail sales, and consumer sentiment this week. Inflation is expected to post around 8.1%. Lower inflation would likely boost markets, whereas higher inflation would likely see markets sell off again.

  • Last week’s unemployment rate was generally positive: a drop from 3.6% to 3.5%, and more jobs than expected were created. This sent markets into a tailspin as investors moved away from a “the Fed is almost done” attitude toward a “the Fed is going to keep hiking rates.” As I have mentioned before, the underlying economy has remained fairly robust to the Fed’s actions so far. In my view, it is ultimately the economic data and corporate profits which drive prices.

The Details

I have tried to avoid it, but we have to talk about the war in Ukraine.

Of course, most people are rooting for Ukraine to prevail. However, exactly what the response of Europe and the United States should be to Putin’s aggressive invasion of his neighbor has become a politically-charged topic. It is not my intent to weigh in on the politics of the conflict, rather, I want to consider some high-level risks facing investors from the ongoing conflict.

First, as we have seen, the conflict has exacerbated inflation. Energy costs have ballooned, and grain costs have also jumped considerably. We have also seen many large companies work to divest their Russia-based holdings, partly in response to sanctions, but partly as a show of solidarity with Ukraine.

There is a deeper risk, however. Ukraine has become a proxy war between the US, her allies, and Russia. Which brings back many cold war era geopolitical risks. World War I showed us that regional proxy wars can ignite wider and more damaging confrontations, for example. Those wider confrontations change the nature of economies and therefore the investment landscape—especially when the largest economies in the world are involved.

From a consequence perspective (though not a probability perspective), the biggest risk is that nuclear-armed states are pulled into a hot war with one another. Since the dawn of the nuclear age, a direct war between nuclear-armed states has been avoided (because no one is sure how it would end), but past behavior is no guarantee of future results. And this risk, while unlikely, seems worth paying a high price to hedge away because the consequences are so large.

As this war becomes drawn out, these geopolitical risks grow. Investors should be mindful of the role they play in their portfolio allocation and risk-management. Again, I see these risks as small, and I do not claim the sky is falling. However, it would be equally foolish to claim that all is well on the eastern front.

Chart of the Week

This week’s chart is very simple: it shows the percentage of revenue earned internationally and domestically by companies in the S&P 500. What becomes obvious is that the 500 largest US companies are quite geographically diversified, which is both good and bad.

The good side means that these companies continue to expand into new markets, and that a blip in one area of the world has less of an impact on the overall movement of S&P 500 prices.

On the bad side: as the US dollar grows stronger relative to other currencies, the revenues coming from those international holdings becomes worth less when converted back to the US dollar. There are some tricks for offsetting that risk, but, ultimately, currency risks are something that companies just have to bear.

With the dollar growing stronger, existing international holdings become more of a drag on performance for US-based investors. For non-US-based investors, this exchange-rate move makes US markets considerably more attractive than they have been in a while.

source: FactSet Research Systems

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