Inflation: 'We expect to see weakness in earnings' heading into 2023, strategist says

CAPTRUST CIO Michael Vogelzang and UBS Managing Director and CIO of Emerging Markets Americas for Global Wealth Management Alejo Czerwonko join Yahoo Finance Live to discuss how inflation is impacting company earnings results.

Video transcript

- But heading into the bell here, we see more red than green, guys.

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All right, there now your closing bell on Wall Street-- let's check out how the numbers closed for the day-- a lot of red on the board, down about 100 points on the Dow, 25 or so on the S&P, and the NASDAQ sliding also just less than 1%, all red.

Closer look at the broader markets-- let's bring in Alejo, chief-- UBS chief investor of Emerging Markets Americas for Global Wealth Management and Mike Vogelzang, CAPTRUST CIO. Mike, anything to learn from the broader market action? But more importantly, earnings-- we've seen a lot of earnings. But have you got any indication that, indeed, that recession that everyone's talking about is coming?

MICHAEL VOGELZANG: Yeah. That's the sort of sword point that the market's fighting with right now. We've had-- the first 25% of the market down drop this year has been sort of valuation compression. As interest rates have risen, equity values have fallen. I think now, the bears are sort of looking at the likelihood or not of a earnings recession next year-- down 15%, 20% in earnings. If that comes through, I think we're going to get some more downside. But if we don't, if we can hang-- get earnings to hang in there, I think we actually might have seen the bottom. So-- at this point. So we'll see. But that's really the tug-of-war that's going on.

- An optimistic view there. Alejo, what do you think? Do you agree? Have you seen the bottom?

ALEJO CZERWONKO: Look, I think the next three to six months are going to be quite challenging for risk assets. Until we see a clear indication that the Fed has reached a terminal rate, things are going to remain choppy. Things are going to remain uncertain. We're positioning portfolios to protect against downside at the same time that we try to allow these portfolios to maintain exposure to medium to longer term upside. We do believe that earnings are likely going to compress in the US in the next 12 months on the-- in an environment of pretty depressed economic activity. And this is not fully priced in as we speak.

- So Alejo, what did you make then of those comments from Neel Kashkari that the Fed may have to push rates above 4.75%?

ALEJO CZERWONKO: Look. I mean, this has been the story of the last 12 months. Standing in January of this year, terminal rate was supposed to be 0%, in March, 1 and 1/2%, in June, 3%, in September, 4 and 1/2%. We're standing right now today with market pricing at a terminal rate of 5%.

What are the balance of risks from this terminal rate levels expectations? I think they continue to be tilted to the upside. Therefore, the conclusion that the next three to six months are not going to be easy for investors--

- Mike, when you take a look at maybe that risk-reward balance here in the markets, what makes sense at this point in the cycle? Where are you seeing, I guess, the most value right now when you're trying to figure out what to do with the portfolio?

MICHAEL VOGELZANG: Yeah. It's a really difficult question in an equity portfolio today. I mean, obviously, the defensive sectors have held in beautifully. Energy is leading the way, as I think it's the only sector up this year.

Without-- the real trouble with earnings is, so far, they haven't fallen much as a block in the S&P 500. But that's because equity-- I'm sorry, energy earnings are up so much. This quarter, I think they're supposed to be up 115%. So without that, actually, the S&P is already beginning to fade earnings down 3% or 4% for this coming quarter if things continue to play out.

So it's very clear. Your decision as to whether or not you remain defensive-- that is, consumer staples and health care and potentially utilities, but particularly energy in this environment-- is really your outlook on higher interest rates. I don't disagree with Alejo. The point here is going to be the Fed is going to do what the Fed's going to do. And they've been very clear about their discipline and the fight against inflation. So I think we simply take them at their word and assume it's going to be a fairly choppy market for a while.

- And if we do take them at their word, Alejo, how do you position yourself?

ALEJO CZERWONKO: It correlates very well with what we've heard. We're talking about quality defensive bias in portfolios. In equities, this means value preferred to growth. It means defensive sectors, such as consumer staples, preferred to more cyclical sectors, such as consumer discretionary. In fixed income, it means take credit risk responsively. Selectively remain in the shorter to intermediate spectrum of the duration side of the equation. You know, in a way, hunker down for at least a few months. But important message here is, at the same time, keep some exposure to the upside because we do think that 12 months from now, the investment environment is going to be much superior than it is today.

- Mike, I know a lot of the focus here is on earnings. We're waiting for IBM and Tesla. Both of those are expected to cross now any minute. It's very, very early in the quarter in terms of what-- the earnings that we've gotten so far. But the number and the magnitude of the positive earnings and revenue surprises have been smaller than what we've seen in terms of recent averages. I guess, do you expect that to continue? Where do you expect to see some of that outperformance?

MICHAEL VOGELZANG: It's hard to see how earnings are going to accelerate here, right, above and beyond expectations. So-- not a surprise if we underperform expectations a bit. We're reasonably happy with how it's coming so far with less than 15% of the S&P reporting.

One of the things that's interesting to note under the surface is that, you know, revenues have actually been doing OK. They've been doing better than earnings growth. That means margins are beginning to get squeezed by inflation. And I think you're going to see that more.

The question is-- when revenue growth drives up, as margins have already been begun to collapse a little bit, we expect to see some significant weakness in earnings going forward, particularly in 2023. So that's the dilemma. That's the question. And that's the point of sort of being defensive, hunkering down.

The only, really, worry we have about that outlook is that it's almost consensus in the market. There's not many people who don't expect a softening in the economy and not a lot of people who don't expect an earnings recession. So you're seeing all kinds of very, very interesting valuations in some of the deep cyclical names, whether it's housing, whether it's energy, frankly, you know, some retailers. They're just incredibly inexpensive. The market's clearly anticipating much, much worse news that's coming. I think it makes some sense to have a little bit of that in your portfolio.

- All right. Mike Vogelzang and Alejo Czerwonko, thanks so much for joining us today-- really appreciate it.