The path of equity markets this year will be determined by the outlook for inflation, monetary policy, and growth.
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, 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.
With 143 companies reporting (37.4% of market capitalization), our current estimate for 4Q22 S&P 500 operating earnings per share is $51.72. If realized, this would represent a year-over-year decline of 8.8%, but quarter-over-quarter growth of 2.7%. Thus far, 60% of companies have beaten earnings estimates while 49% of companies have beaten revenue estimates, and both earnings and revenue surprises have been lower than their historical averages. Meanwhile, profit margins are holding up better than expected, with our current 4Q operating margin estimate tracking 11.5%, and buybacks have been additive to earnings so far.
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.
Costs keep on rising
Similar to last quarter, the energy and utilities sectors look to have seen the strongest profit growth. Earnings in both sectors have been boosted by strong energy prices, with crude oil and natural gas prices, on average, +7.2% and +13.7% in 4Q22 versus 4Q21. While energy inflation has moderated in recent months, the historic increases we saw in mid-2022 should support utility companies, as regulators typically increase allowed return on equity following surges in costs. Within energy, there have been isolated instances of softness among the energy equipment & services companies due to a slowdown in demand; however, this is expected to be more than offset by the sector’s oil & gas names.
Earnings in the materials sector are tracking a year-over-year decline, as falling commodity prices, slowing manufacturing demand and a stronger U.S. dollar all weighed on profitability. The materials sector has significant exposure to the international markets, with 55% of the sector’s sales coming from outside the U.S. At the industry level, construction materials could see an acute decline due to the pull-back in the residential real estate market.
Despite weakening demand for goods, the industrial sector is set to see earnings grow 31.4% y/y, primarily due to strong results among the airlines. During earnings calls, many management teams highlighted resilient demand, even as ticket fares continued to increase in 4Q22. Notably, many airlines also saw a jump in the demand for premium fares, which helped further offset the impact of higher fuel costs and operating expenses. Other beneficiaries of robust air travel are the aerospace companies, many of whom have reported solid gains in aircraft servicing revenues. While still positive, earnings among the transport and freight companies have been mixed so far due to slowing demand and higher costs.
The consumer sectors are set for a difficult quarter of earnings, as higher inflation and souring consumer confidence weigh on spending. With that being said, consumer staples should see earnings remain somewhat more resilient relative to consumer discretionary. The key question for companies in both sectors will be whether they can reduce bloated inventories as pricing gains begin to wane and costs remain high. Within consumer discretionary, the autos will be in the spotlight, as early reports have indicated ongoing production issues and a deceleration in price increases, which, in contrast to recent quarters, will weigh on margins as demand ebbs.
Information technology and communication services look set for tough quarters of earnings as well. Current estimates are pointing towards a small contraction in the tech sector, as analysts expect the moderation in the demand for hardware to be offset by software and mixed semiconductor results. Communication services, on other hand, is much more levered to discretionary spending and has seen strong job growth over the last 12 months, suggesting labor costs will continue to pressure earnings.
As per current estimates, the health care sector is tracking year-over-year earnings growth of 5.7% due to the sector’s diversified mix of growth and value names. In general, labor costs seem to be the biggest pain point, as a tight labor market forces companies and hospitals to offer higher wages in order to remain and attract employment. Within the sector, companies highly levered to COVID-19 vaccine sales and related products have seen earnings contractions as we move into a post-pandemic world.
So far this earnings season, a handful of themes have emerged that will likely be relevant as we kick off 2023. Starting with the financial sector, earnings have struggled yet again as continued reserve build and slowing mortgage and investment banking activity eat away at bottom-line results. Global M&A activity on a deal count and deal size basis were down 32% and 50% y/y, respectively, in the fourth quarter of 2022. It is unlikely that deal-making improves in the current quarter, with slowing economic growth and a deterioration in credit quality likely to postpone any previously planned deals. Additionally, while net interest income is currently providing support for earnings, the benefit to net interest margins (NMs) should erode in the coming quarters as the deposit mix shift continues and deposit betas pickup. Lastly, while trading revenues have been down, fixed income trading, specifically, has benefitted from elevated levels of rate volatility. Overall, the money center banks have fared better than the large investment banks, given the former have a more diversified business mix. Among the smaller regionals, credit quality will be key, and those with relatively higher exposure to subprime credit will be forced to put aside more in provisions.
The second trend to watch is whether companies can maintain pricing power, as price gains are now lagging behind the increase in costs/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 managements 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.
Investment implications
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.
Volatility should persist in the first half of the year, which against a backdrop of higher rates, should help investors differentiate between winners and losers and support active managers. Above all, cash flow will be king in 2023 - we continue to favor short duration equities that are returning cash to shareholders via dividends and buybacks. That said, valuations in the growthier parts of the market are beginning to look attractive, and we see an opportunity emerging in the profitable parts of these sectors as monetary policy potentially turns more accommodative towards the end of the year.