Earnings Outlook: Overweight Consumer Staples as Q3 Earnings Season Starts

Summary 

• Another robust labour market report should lay to rest concerns about the economy for now. 
• Equities seem to be settling into a new range as the 10Y Treasury yield trades between 4.6% and 4.8%. We think the market has priced in a view that the Federal Reserve (Fed) could raise rates to 6% then hold. 

• In coming days, renewed conflict in the Middle East could lead to volatility, especially if oil supply and price are affected, but we expect this will soon settle. 
• Earnings season opens with major reports from PepsiCo (PEP) and the bulge-bracket banks.  
• We think the selloff in consumer staples and especially companies like PEP and Coca-Cola on diet concerns is overdone.  

Market Implications 

• We like to be tactically overweight in the consumer staples ETF XLP and PEP/KO. 

What We Learned Last Week 

Whatever happens in coming days and weeks, markets should have little to worry about the economy sliding into a slump in coming months. The September payroll report made it clear that the labour market remains tight and that consumers have income to spend – even if less than they would like.  

So focus returns to the Fed and rates.  

Equities sold off sharply as the 10Y Treasury rose from 4.3% to 4.6%, but then traded in a narrow range as yields rose to 4.8% (Chart 1). Further, equities rallied nicely from March to late July even as the Fed continued raising rates and the 10Y Treasury yield rose from 3.5% to 4.0%. The 2023 selloff came only when the Fed dashed the market’s hope throughout 2023 that it would go on hold once Fed Funds reached 5.00-5.25%. 

We now think equity markets have recalibrated expectations and are prepared to see Fed Funds rise as high as 6.00-6.25%. The base case then is that equities settle into a new range for now. 

Apart from significant deterioration in the economic outlook, two key factors that could upset that balance are geopolitical concerns and earnings. 

Middle East – Again – The latest outbreak of hostilities between Israel and Hamas may cause volatility on concerns about whether the conflict spreads and the impact on oil supplies and price. We expect this volatility to be short-lived. 

Earnings Season Opens – Third quarter earnings season opens this week, and that will be the other big factor that could cause further repricing of equities. Currently, analysts expect quarter-over-quarter earnings to be up 2% for the S&P 500 (SPX) and a substantial 10% for the NASDAQ 100 (NDX). This departs from recent quarters when earnings forecasts were flat or even down. Analysts may have decided that they have been too conservative, or perhaps earnings are reflecting an economy that is continuing to normalize.  

It is hard to call how this earnings season may differ from recent ones, but we expect the key variable to be company outlooks.  

Trade Idea of the Week 

Last week, we liked to unwind underweights in the Russell 2000 ETF (IWM) and homebuilders (XHB). These interest-sensitive trades outperformed as rates rose over the past two months. 

Now, we like to be overweight in consumer staples (XLP) and PepsiCo (PEP). XLP has underperformed in recent months largely because rising interest rates have made the dividend less attractive. In a note last week, we said a number of large food and grocery companies were hit when Walmart said growing consumption of appetite suppressing drugs such as Ozempic were depressing grocery sales (a problem also flagged by Conagra (CAG)). Soft drink and snack giants PepsiCo and Coca-Cola sold off by 5.1% and 3.7%, respectively. 

We see this as clearly overdone. PEP reports earnings on tomorrow; we expect a technical bounce then. 

The Week Ahead 

It will be another light week for earnings, with only 12 companies reporting. Still, several are major bellwethers – including the bulge bracket major banks – that could set the tone for the big crush that arrives next week. 

Tuesday 

• PEP has wowed investors so far this year, reporting double-digit price increases on its product lines with little impact on demand. The latest report may be a tad more moderate, but we would be amazed if people have simply lost appetite for PEP offerings. 

Thursday 

• We know people are cutting back, but they still seem to be eating out – Domino’s Pizza (DPZ) will update us on how the convenience of carryout is faring. 

• Fastenal (FAST), maker of fasteners that many industrial companies need, has had a lean year so far as many customers run down excess inventories – we expect demand may be returning to normal. 
• Delta Airlines (DAL) should report ongoing robust demand for air travel and concerns about higher jet fuel prices. 

Friday 

• Citigroup (C), JP Morgan Chase (JPM), and Wells Fargo (WFC) should report good loan demand and perhaps rising interest income on higher rates. Investor focus may be on the potential impact of higher rates going forward. 
• PNC Financial (PNC) gives an early read on what large regional banks are seeing across middle market companies.  

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)