What awaits the stock markets after the recent falls?

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Schroders Multi Regional Equities portfolio manager Frank Thormann explains what types of companies could offer some shine after a dark period for the stock markets.

Global equities have had a tough few weeks and have fallen particularly sharply since the US Federal Reserve (Fed) raised interest rates by 50 basis points (0.50%) on May 4.

For once, the US is performing below average, with its heavy weighting in technology and growth stocks playing against it.

As equity investors, one of our main sources of information on what’s going on comes in the form of quarterly reporting seasons. These see listed companies provide detailed explanations of what they see on a day-to-day basis; what changes and what does not change.

Last earnings season positive, but clouds for some sectors

The reporting season for the first quarter has just ended. In fact, for the vast majority of companies, the business climate remains rather positive, posting strong growth in revenues and profits. It has by no means been as robust as 2021, but for companies listed on the U.S. S&P 500 stock index, revenues and profits grew by a small percentage of teenagers.

Looking ahead to the rest of the year, earnings estimates aren’t being revised up, but neither are they falling dramatically. I would say that’s a pretty strong achievement.

However, there are sectors that are in more difficulty and where clouds are gathering on the horizon.

One sector that saw lower profits in the first quarter was financial services, particularly banking. This is largely explained by an increase in provisions. Provisions are funds that are set aside in anticipation of future losses. It should be remembered that banks’ bad debt losses have been low for a very long time, so provisions have increased from a level that is probably unsustainable.

It is possible that many of these provisions will be short-lived. The big question will be whether the US Fed can engineer a soft economic landing or if the economy will eventually slip into a recession. Obviously, if we end up in a recession, banks could face an increase in bad debts.

Another sector going through a tough time is manufacturing. Anything that involves manufacturing physical goods and shipping them around the world currently faces a very complex situation. There is a lot of cost pressure in supply chains.

Suppliers of “mission-critical” goods or services will fare best

This cost pressure, and the ability of companies to pass cost increases on to customers, is the key thing that we as stockpickers are focusing on right now. In a nutshell, the source of “price power” – or the ability to raise prices without destroying demand – comes from having a product or service that is essential or mission critical.

It may be real, or it may be a matter of perception. Take Coca-Cola, for example. If you go to the supermarket you will find it next to own brand equivalents which cost a fraction of the price and taste more or less the same. But customers perceive that Coca-Cola is unique, and this has enabled the company to push through a price increase of around 7% year-over-year.

An example in technology at Microsoft. Microsoft’s suite of tools is probably essential for most office workers. It’s hard to see such companies canceling their Microsoft contract just because Microsoft raises prices a bit.

These types of businesses are able to withstand the inflationary environment very well.

The energy sector could surprise by limiting its spending

One sector under close scrutiny at the moment is energy, given the rise in the price of oil this year. We believe that oil prices should remain relatively robust.

Another pleasant surprise could be capital discipline, ie the control of expenses. This is a concept that was quite foreign to the energy sector in the past. However, we are now seeing companies refraining from increasing drilling activity at all costs. Instead, they focus on generating free cash flow and returning that cash to shareholders.

This combination means that energy remains an area of ​​interest for us.

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