With financial conditions tightening, focus has shifted on the business cycle. Four main phases are defined in a business cycle: recovery, expansion, slowdown, and contraction. Its fluctuation and duration are largely dependent on the level of growth and credit availability in the economy.

Today’s high inflation, resilient activity, and tight labour markets, while central banks tighten, represents a late cycle economic environment. Risk premiums have also remained low, which has anchored equity market volatility, and stands as another typical late cycle characteristic.

The recent banking turmoil is expected to lead to further credit tightening, as banks become more conservative to safeguard capital and maintain liquidity. This expectation has reduced the level of how much further interest rates need to rise. Evidence of credit tightening is already seen across both Europe and the US.

In Europe, the ECB’s Bank Lending Survey published at the beginning of May shows that credit standards to households and firms tightened more than expected. Demand for loans has also plunged, driven by higher interest rates, lower financing needs for fixed investments and weaker housing market dynamics.

Similarly in the US, tightening in lending standards started during the second half of last year. More recently, the April Senior Loan Office Opinion Survey on Bank Lending Practices showed a higher percentage of banks tightening their lending standards, and more importantly, a sharp decline in demand for loans to levels last seen during recessionary periods.

The first-quarter earnings season has presented investors a timely opportunity to understand the trajectory of the eco­nomy from a bottom-up pers­pective. Across both regions, equity markets delivered results that beat expectations. Earnings delivered a positive surprise of 25% in Europe and 6% earnings per share beat those in the US. This highlights that earnings expectations prior to the start of earnings season were too low.

In the US, expected earnings decline was around -6.7% compared to the actual decline of around -3%. More positively, earnings grew in Europe, outperforming the US. Cyclical sectors delivered most of the better-than-expected results, particularly consumer discretionary and financials. While US profits are falling, the sales growth remains positive. Both regions recorded a sales growth of around 4%, beating expectations by around 2%.

Despite the challenging macro-economic backdrop, economic activity has proved more resilient than expected, which has been good for earnings. The strong e­qui­ty markets performance year-to-date has been consistent with the improvement of Purchasing Manager Indices readings.

Despite the challenging macro-economic backdrop, economic activity has proved more resilient than expected, which has been good for earnings.- Rachel Meilak

Such leading economic indicators have shifted from a contractionary to an expansionary level, supported by the strength of the services sectors, as Europe managed to avoid an energy-driven deep recession and China delivered a faster reopening from its covid-19 lockdown measures.

Another takeaway is that while companies noted the strength of underlying business, guidance on outlook remained conservative. Across Europe, corporate sentiment on the economic outlook has softened again, citing economic concerns, and a negative impact from a stronger euro. Optimism about China’s recovery post-reopening was also noted, as Europe enjoys the second-highest exposure of any region to China.

While the overall economic resilience has been supported by the services sectors, manufacturing indicators remain weak. In this regard, comments on inventory management from company earnings updates were also key. It was confirmed that the inventory destocking was worse and taking longer than anticipated. This mostly impacted the goods, semiconductors, and transportation sectors.

The number of companies that have cited the term inflation in their earnings call, according to Factset, has declined for the third consecutive quarter. This coincides with the downtrend from peak inflation levels. While this can suggest that inflation concerns are moderating, companies still comment that it remains a persistent issue, wary of labour cost inflation offsetting moderation in input costs.

The latest round of earnings managed to support the current positivity across equity markets year-to-date. Going forward, tighter lending standards, together with higher interest rates, are likely to drive economic growth lower. However, equity markets may only start to be concerned when labour markets and consumer resilience deteriorate.

Positioning across high quality segments of the economy should provide better resilience amid the current economic uncertainty. Focus should remain on companies that are in a better position to navigate any downside risks, including those that enjoy resilient demand, or form part of strong secular growth trends, such as sustainability and digitalisation, that should benefit irrespective of how the current business cycle plays out.

Rachel Meilak, CFA, is a portfolio manager at BOV Asset Management Ltd.

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