Earnings could become the market’s 'greatest risk' next year, strategist warns

Michael Arone, Chief Investment Strategist for the US SPDR business at State Street Global Advisors, joins Yahoo Finance Live to discuss how markets are faring on Monday, the outlook for rising interest rates and protecting your portfolio amid the pandemic.

Video transcript

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BRIAN SOZZI: The bulls are doing their best to stay in control of a clearly nervous market, but will they regain the narrative heading into October? Michael Arone is the Chief Investment Strategist at State Street Global Advisors, and joins us now. Mike, good to see you again here. We're seeing the NASDAQ under pressure here, I think, in large part because of the move higher in 10-year yields. How concerned are you about that move in yields?

MICHAEL ARONE: I'm not overly concerned about the move in yields, Brian. I do think that it reflects this idea that the Delta surge is beginning to wane, and you're starting to see some of the good news in economic data. The economic data we got this morning beat expectations. So I think folks are anticipating a revival in economic growth, and the growth scare is abating some.

Combined with the fact that inflation continues to be stickier than the Fed anticipated and that many market watchers anticipated. And I think that's pushing upward move on rates and downward pressure on some of those longer-duration growth assets.

BRIAN SOZZI: Well, let's look at from another angle here, Michael, on yields. Is this an indication that investors are starting to get some concern that we might get that government shutdown?

MICHAEL ARONE: I'm not sure we're kind of-- I'm not sure investors are overly concerned right now with the government shutdown. I do think, Brian, that it is going to take center stage this week in terms of government shutdown, what's going to go on with the Biden administration's policy agenda, and, certainly, the uncertainty about the debt ceiling. This will result in some short term market volatility.

But again, I think at the 11th hour cooler heads will prevail, and we'll get resolutions on all these things, with some compromise. But until then, though, I do think that the markets get a little bit tenuous, in terms of the uncertainty here. The way I think about this is that we were able to ignore so much of this noise during the second-quarter earnings season because the numbers were so good. Now we're kind of in an earnings vacuum, we're in between the second and third-quarter earnings announcements, the earnings season, and all of a sudden, a lot of this noise starts to matter a little bit more-- Evergrande, DC dysfunction, the Fed, COVID, those types of things. But I think we'll get through it.

BRIAN CHEUNG: Hey, Michael. Brian Cheung here. I mean, what are you seeing in terms of rotation? Because what is interesting is-- we were talking with Mike Wilson not so long ago, at least before the Evergrande situation-- but the idea is that we have seen categories like consumer discretionary and autos outperform-- or rather, they've actually lagged. So I guess I'm wondering what are you seeing in that space, in terms of where people are deciding to put their money within equities?

MICHAEL ARONE: So I think one of the things we have suggested investors think about is moving towards a more quality posturing, as well as some dividend payers and dividend growers, and US small-cap stocks. So our view is that the cyclical trade is likely to continue to have some legs as the economy recovers and there continues to be upward bias on rates and inflation. However, many of our investors have already done that.

The growth trades, as we're talking about, are going to be challenged, with the potential for higher rates. So now, as we get to an environment where there's concerns about growth, there's concerns about China, DC dysfunction, what is the Fed going to do, we think a pivot towards higher-quality companies, those that are either paying or increasing dividends, and US small caps makes a lot of sense. And in fact, Brian, over the last few months, companies with more stable and healthier balance sheets and a more predictable earnings pattern have beat the broader market by about 3%. We think that trend will continue.

JULIE HYMAN: Hey, Mike. As we get into-- as you said, we're in sort of a vacuum here, if you will, in between earning seasons-- when we get into the next one, are those higher-quality companies going to still be able to perform? Because we've seen, certainly, a lot thrown at them, in terms of challenges from supply chains, inflation, labor shortages. So are they going to still be able to hold up?

MICHAEL ARONE: I do think they will be able to continue to perform. And so one of the things I think that's interesting is, in the most recent quarter in aggregate market, profit margins were actually at their highest level since FactSet Research Systems kept the data. So this idea that building inflationary pressures, rising input costs really hurt profit margins-- now, Julie, you and I both know that's a market cap weighted. So certainly, all the great profit margins on the FAANG stocks helps in that regard.

But so far, profitability in aggregate for the market has remained healthy. Now, it's going to come in some, but I don't think it's going to be the big watershed event for the next earnings season. Now, I do agree that, going forward, earnings has been the primary driver of the market's returns this year, and I do think it could become the market's greatest risk in the next year, in that now analysts are beginning to cut their estimates for next year.

And in fact, if companies don't step over that lower bar like they typically do, all of a sudden, that's a change in investor psychology, and I do think that that could be a risk later in the year and into next.

BRIAN SOZZI: Point well taken. Michael Arone is the Chief Investment Strategist at State Street Global Advisors. Always good to see you, Michael.