In brief

• The 4Q22 U.S. earnings season so far saw less earnings and revenue beats compared to historical averages, with operating earnings per share seeing a year-over-year (y/y) decline of 11.9%.
• Maintaining pricing power and protecting margins will be key for companies this year, especially as price gains fail to catch up with input price inflation. Various technology companies and banks have announced job cuts in 2023.
• Inflation, monetary policy and growth will be the key factors impacting earnings and equity returns this year.Fixed income markets have kick-started 2023 in a positive manner. While a hawkish U.S. Federal Reserve (Fed) and high inflation weighed on bonds in 2022, these headwinds have started to abate in  2023. Undoubtedly as rates peak and disinflationary momentum sets in, this will act as fodder for positive fixed income performance. For a more concrete outlook on the fixed income space, however, investors will want to look for further clarity in direction and destination of yields as well as assess the impact of slowing growth on spreads and defaults.

2022 was a year to forget in the capital markets. Stock/bond correlations turned positive and left traditional investors with nowhere to hide as volatility spiked and prices plunged. Now that the dust has settled, it is overwhelmingly clear that last year was all about a re-rating in valuations. Today in the U.S., however, the overarching concern is about the outlook for earnings, as net revisions have turned increasingly negative and forward estimates have begun to decline more meaningfully.

How are the results so far?

With 348 companies reporting (80.2% of market capitalization), our current estimate for 4Q22 S&P 500 operating earnings per share is $49.97. If realized, this would represent a y/y decline of 11.9% and a quarter-over-quarter decline of 0.7%. Thus far, 63% of companies have beaten earnings estimates while 53% of companies have beaten revenue estimates, and both earnings and revenue surprises have been lower than their historical averages.

Exhibit 1: S&P 500 net earnings revisions

Last 10 years, %, 3-month moving average

Source: FactSet, J.P. Morgan Asset Management. *Net revisions are a 3-month moving average and calculated as: (upgrades - downgrades)/(upgrades + downgrades + unchanged). Data are as of January 27, 2023.

Inflation should gradually decline over the course of the year, but in the interim provide support for revenues in an environment where real growth is coming under pressure. This means that earnings growth will primarily be a function of a company’s ability to defend margins. If the economy is able to avoid recession, we would expect S&P 500 operating earnings to be about flat; whereas, if we have a recession, then earnings are likely to decline 10-15%. Importantly, we struggle to see a more severe decline in profits because of this inflation dynamic, although support from price growth will fade as the year goes on. From an equity market perspective, we anticipate that investors will reward those companies who are able to generate organic earnings growth in 2023, relative to those that simply benefit from higher prices.

What are companies focusing on?

A key trend to watch is whether companies can maintain pricing power, as price gains are now lagging behind the increase in cost inflation. While companies, in general, continue to charge higher prices in an effort to defend margins, input price inflation has begun to ease. We have seen a steady month-over-month decline in input costs since 2H22, which has coincided with less aggressive increases in prices. Unfortunately, dynamics on the demand side look unfavorable too, with softer demand putting a cap on additional price hikes and adding further pressure on margins.

Adding to the profit pain is unfavorable FX conditions (the U.S. dollar strengthened, on average 14.9% y/y, during 4Q22), business divestures from Russia, record growth in headcount and lingering COVID-19 restrictions in China. The bottom-line is that with the sticky nature of wage inflation and a deceleration in prices and demand, companies will need to find alternative levers to pull in order maintain profitability. For many companies, the easiest and likeliest solution is job cuts. Of course, this will be less urgent for companies providing nondiscretionary goods and services (i.e. staples, oil & gas, pharmaceuticals).

In an effort to defend margins, companies are announcing cuts going into 2023. Plans to cut headcount and slash compensation have been particularly acute at tech companies and investment banks, as margins come under pressure due to higher costs and a slowdown in demand. The misalignment in headcount and current needs is also exacerbated by the fact many of these companies over-hired during the re-opening. Going forward, a number of management teams have highlighted that they will need to “do more with less.” Finally, the business mix within sectors will be key. For example, the information technology sector is comprised of both hardware and software companies. With the world becoming increasingly “digital,” software has transitioned, for many firms, to being an “essential” service. From a cost perspective, adopting innovative software is key, as it can be a deflationary force in an inflationary world. In contrast to the tech sector, communication services is heavily concentrated to gaming, streaming, advertising and e-commerce – all of which are highly cyclical. As growth continues to slow and costs remain sticky, the sector’s margins will face increasing pressure.

Another example is the industrial sector, where earnings projections for the sector in aggregate indicate year-over-year growth, but at the industry level results are far more varied. Strong spending on services, particularly on travel, has buoyed profits among the airlines and aerospace industries. On the other hand, spending on goods saw a noticeable decrease in the fourth quarter, with many of the manufacturing and finished goods- oriented industries reporting declines in sales. These companies are also facing the added headwinds of ongoing supply shortages and increasing costs. While a majority of S&P 500 layoffs have been in the tech and financial sectors, within industrials, notable layoff announcements have been isolated in the manufacturing industries.

What does this mean for equity markets this year?

The path of equity markets this year will be determined by the outlook for inflation, monetary policy, and growth. While these three factors will undoubtedly impact profitability, equity returns could end up being positive even if earnings decline. Markets are inherently forward looking, which suggests that more clarity on the issues above could lead investors to focus on a brighter tomorrow, even if that is yet to be reflected in the data.

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