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Weak earnings season may force Fed into dovish turn

The Federal Reserve might be forced to soften its approach to tightening monetary policy if third-quarter corporate earnings fall short of expectations.

Investors expect the Fed to begin tapering the central bank's $120 billion-per-month asset purchase program this year ahead of a possible rate rise in 2022 as inflation persists. Market watchers suggest the Fed may have to ease either its pace of tightening or its tone, or equities could fall substantially on disappointing earnings results and a more hawkish central bank. Analysts expect slower year-over-year growth in third-quarter corporate results than earlier in the year.

"If earnings season doesn't look too good, and there are some nasty forecasts from corporates, I would play a dovish hand," Gregory Venizelos, senior credit strategist at AXA Investment Managers, said in an interview. Stocks could correct by 5% to 10% if the Fed is "too hawkish" when it tightens, Venizelos said.

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Earnings season has started strongly for U.S. financials companies with JPMorgan Chase & Co. and Bank of America Corp. among those to beat analyst expectations. Still, factors including logistical blockages, supply chain bottlenecks and rising energy costs threaten to eat into the margins of other U.S. companies more reliant on selling physical goods.

Expectations for growth in S&P 500 EPS have narrowed to 27% year over year in the third quarter as of Oct. 20, well below increases of 42.1% and 88.3% in the first two quarters of 2021, according to S&P Global Market Intelligence data. The third-quarter EPS estimate for the S&P 500 represents a 5.6% decline over the previous three months.

Earnings slump

The expected earnings growth rate has fallen back from earlier quarters for all sectors besides energy, which benefited from a boom in oil and gas prices, according to Market Intelligence data. The consumer discretionary sector is expected to post the largest year-over-year decline in earnings at 14%.

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"[Earnings season] is arguably more important than ever," Ben Laidler, global markets strategist at multiasset investment platform eToro, said in an email. "We see another strong earnings beat, above the plus 27% S&P 500 consensus growth versus the same quarter last year, led by energy, materials, and industrials."

There are other signs of distress outside the financial sector. Sportswear company Nike Inc. lowered its revenue outlook in September for its current fiscal year that ends in mid-2022, citing 10 weeks of lost production at its Vietnamese factories and shipping delays. Apple Inc. is reportedly set to cut its iPhone 13 production target for 2021 by up to 10 million units due to chip shortages.

"We have seen better results from the banks, but it is too early to say other sectors are going to beat expectations too," Fawad Razaqzada, market analyst at ThinkMarkets, said in an email.

Strong earnings results from financial companies helped boost the S&P 500 in recent days, with more than 80% of the first 41 companies beating third-quarter expectations. The index rose 1.7% on Oct. 14, its best day in seven months, according to S&P Dow Jones Indices.

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That followed a period of relative weakness for equities. The dual prospect of the Fed tightening policy — perhaps as early as November — and a peak in earnings led to a 5.2% drop in the S&P 500 from the index peak on Sept. 2 to the low point on Oct. 4, just days before the current earnings season began.

U.S. stocks may not get much of a boost from the current earnings season, even if more companies offer better-than-expected forecasts, according to consultancy Capital Markets.

Stretched valuations

The S&P 500 has been on a tear since the arrival of COVID-19 tanked financial markets. The benchmark index has doubled since the low point in March 2020, reaching new highs along the way.

Low bond yields brought about by the Fed's asset purchases and the expectation of a strong economic recovery drove investors into riskier assets such as equities. The rush into stocks and collapse in corporate sales as the pandemic took hold meant that valuations were stretched to historically high levels before government stimulus checks aided a consumer recovery, boosting earnings.

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The forward P/E ratio — a measure of valuation devised by dividing 12-month forward earnings by the share price — was 21.7 as of Oct. 19. Before the pandemic, the last time the ratio was above 20 was in 2002, during the market downturn that followed the bursting of the dot-com bubble. Tech stock valuations had surged leading up to the bubble bursting in March 2000.

Those high valuations mean stocks may only go down if the Fed follows through with current plans to taper and raise interest rates. Pulling out of the government bond market will likely lead to falling prices and rising yields, which move in opposite directions. Higher yields in the less-risky bond market might lead investors to move away from stocks.

Fed reaction

Falling corporate earnings will likely erode stock valuations, AXA's Venizelos said. Investors expect the Fed will announce its tapering plans in November. The trends in corporate earnings and markets at that point will likely determine Chairman Jerome Powell's tone, which is closely followed by analysts.

"I imagine he will try to make a dovish taper," Venizelos said.

Corporate CEOs may offer additional insights during post-earnings conference calls, especially surrounding trends and views of the economy. Those remarks may also play into the Fed's approach.

"If supply chain issues become more of an issue in earnings calls then the Fed will have to take a more cautious approach to how it responds," said Razaqzada, of ThinkMarkets.