Equity markets have found their footing in 2023, demonstrating an unexpected resilience against fears of recession, failures in the banking sector, elevated inflation, and tighter monetary policy. This has led many investors to wonder if we might be out of the woods and embarking on a new bull run, or whether we will re-test the lows at some point in the coming months; although a skeptical outlook among many investors has allowed us to entertain the idea that a new bull run has started, we continue to view the balance of risks as being tilted to the downside. Futures markets continue to price 75bps of interest rates cuts in the second half of the year – a phenomena we believe will fail to materialize – and earnings estimates are still in the process of re-rating. Once again, this leaves us focused on the outlook for corporate profits, as if rate cuts fail to materialize as expected, there will be limited capacity for multiple expansion.

The good news is that the first quarter earnings season has delivered better than expected results. With nearly 50% of market capitalization, reporting, our current estimate implies positive year-over-year and quarter-over-quarter earnings growth. Thus far, earnings and revenue beats have been generally in-line with long-run averages, and importantly, both earnings and revenue surprises have been positive. Meanwhile, and arguably most importantly, profit margins bounced in 1Q23 on the back of cost cutting and pricing power.

As earnings weaken, how do firms manage costs? When do they start cutting capital expenditures and headcount? Historically, if we look at the past four recessions, year-over-year operating earnings growth tends to trough prior to the peak unemployment rate, but still during the recessionary period. Since 1989, earnings growth has troughed an average of 2.75 quarters (8-9 months) prior to the unemployment rate peaking. Excluding the COVID-19 recession, the gap between earnings and unemployment is closer to 10 months.

Similarly, capital expenditures, as measured by nominal private domestic nonresidential fixed investment, tends to bottom an average of 2 quarters (6 – 7 months) after the trough in profits, or one quarter before the unemployment rate peaks. Put simply, for firms, the order of operations when it comes to cutting costs tends to be capex first and then employment.

The past few weeks have seen elevated interest rate volatility, but stock markets have been relatively well behaved. The bottom line is that performance in U.S. equity markets so far this year has been all about rates, a theme that should persist as earnings expectations gradually align with reality. This warrants a cautious approach to equity markets focused on quality and cash flow - defensive value names and profitable growth names seem to fit the bill. However, it will be important for investors to pay attention to the price they are paying for these exposures, as elevated valuations are likely to decline as markets recognize that aggressive monetary easing is not on the near-term horizon.

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