Re-test the lows or a new bull run?

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 75 basis points (bps) 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 265 companies reporting (65.3% of market capitalization), our current estimate for 1Q23 S&P 500 operating earnings per share in USD 51.00. If realized, this would represent year-over-year earnings growth of 3.3%, and quarter-over-quarter growth of 1.3%. Thus far, an impressive 71% of companies have beaten earnings estimates while 65% of companies have beaten revenue estimates, both of which are in line with or above their long-run averages. Importantly, both earnings and revenue surprises have been positive, with earnings beating by an average of 6.2%. Meanwhile, and arguably most importantly, profit margins bounced in 1Q23, with our current estimate tracking 11.5%.

With interest rate expectations too dovish, the risk of recession rising, and profit estimates likely to remain under pressure, it is difficult to be overly bullish on equities at current levels. Furthermore, there is no clear valuation advantage for stocks or bonds at the current juncture. As a result, we are inclined to embrace optionality through shorter duration assets (stocks and bonds), which provide investors with the ability to reinvest cash flows as the outlook for the economy and monetary policy crystalizes. In other words, investors in this environment should focus on hitting singles and doubles, rather than swinging for the fences. 

Pricing power vs. expense management

As was the case in 2022, the outlook for earnings will depend on the ability of companies to defend their profit margins. There are effectively two ways for them to do this – pass along higher costs via higher prices or trim expenses. The earnings season thus far has shown that companies are embracing one of the two, or sometimes both, to maintain current levels of profitability.

Importantly, current estimates indicate a shift in leadership. Energy is no longer at the front of the pack, with the sector tracking year-over-year earnings growth of 14.3% – a significant deceleration from past quarters due to normalizing oil and gas prices. That said, earnings should still find solid support from the oil and equipment services names, which continue to benefit from a chronic underinvestment in drilling capacity over the last few years. In the materials sector, a decrease in input prices along with weakening manufacturing activity will likely drag on results; like oil and gas prices, input prices have moderated as well, with the Producer Price Index (PPI) for crude materials declining 17% year-over-year through the end of 1Q23 and the U.S. ISM manufacturing PMI ending the quarter at 46.3, the lowest reading since May 2020.

Industrials are projected to post another quarter of earnings growth, as resilient demand for air travel has helped offset dwindling profits in machinery, freight, and transport. Moreover, while many airlines recorded losses for 1Q23, demand for airfare remained healthy, with the losses primarily attributable to one-off charges related to salary increases and training programs. Nevertheless, the industry still saw year-over-year growth, as 1Q22 results were marred by COVID-19. Looking ahead, airlines’ management teams provided positive guidance and reiterated their expectations for a strong spring and summer travel season. Within transport, while volumes have decreased across the board, fuel surcharges have, so far, still acted as a tailwind for railroad earnings. Results have also been challenged among the manufacturers and conglomerates, with many reporting softening demand and announcing additional layoffs.

After consecutive quarters of contracting earnings, the financial sector is currently tracking year-over-year earnings growth of 16.8%, as higher interest rates relative to a year prior have helped boost result. However, the benefit from higher net interest income was partially offset by continued provisions for loan losses, sharp declines in M&A and trading activity, and decelerating mortgage revenues. On a quarter-over-quarter basis, financials look set to struggle, as moderating interest rates, higher deposit betas, slowing loan growth, and deposit outflows at the regional level all weigh on results.

Despite a deceleration in consumer spending, both consumer sectors are tracking year-over-year growth in earnings due to poor results in 1Q22, resilient demand for services and core goods, and price increases. Within consumer discretionary, a key focus will be on whether retailers are able to clear excess inventories while maintaining profitability, with early reports suggesting higher markdowns have weighed on margins. However, the drag from bloated inventories should be offset by travel, lodging, food, and restaurants. In contrast, auto companies have seen weaker results as the supply-demand imbalance for vehicles normalizes and operating costs remain persistently high. Importantly, while costs as measured by Consumer Price Index (CPI) and PPI have moderated, the prices for inputs specifically used in auto production still remain high as per management commentary.

The technology sectors are in line to see earnings contract year-over-year. Declining hardware demand will weigh on information technology, with global PC shipments declining 29% year-over-year in 1Q23 per IDC. However, software should provide some offset to this, as these companies tend to have lower fixed costs, large streams of recurring revenues, and have reduced headcount in recent months. Furthermore, cloud and AI related services remain top of mind given the role both play in optimization and cost minimization. For communication services, the contraction in earnings is primarily due to further pullbacks in advertising and discretionary spending along with higher operating costs. However, results so far have surprised to the upside, with advertising revenues coming in stronger than expected but still down relative to a year prior.

Finally, health care is tracking flat to slightly down earnings growth year-over-year. Results so far have indicated that medical devices and technology companies are benefitting from a global rebound in procedural volumes, while health care providers and services are benefitting from strong utilization rates. Additionally, pharmaceutical companies continue to have a strong pipeline of products, but the associated R&D expenses and operating costs could leave them vulnerable if both growth and demand slow.

The anatomy of a cycle

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.

Looking at current commentary, firms plan on reining in investment, but cuts will not be distributed evenly. In fact, many management teams noted that investment in technology, specifically artificial intelligence, will likely increase due to potential cost savings from optimization over the long run. As such, cuts will likely occur in structures and equipment. Within structures, these cuts are likely to be concentrated in manufacturing and mining (exploration, shafts, and wells), as economic activity slows, and energy prices normalize. Within equipment, easing supply chains and a deterioration in services demand would likely lead to lower investment in transport equipment, while investment in information processing equipment (tech hardware) has already begun to slow as demand from the reopening fades. Overall, investment in equipment tends to be quite levered to the cyclical sectors, making it vulnerable to any slowdown in economic activity. Historically, intellectual property products, which includes software, tends to see the least pullback in investment, while equipment tends to see the largest.

Turning to employment, when potential weakness in earnings does filter through into the labor market, where will layoffs be the most acute? Although the labor market has cooled in recent months, strong demand for services has driven robust payroll growth in related industries. Private education and health services and leisure and hospitality have seen a much larger increase in payrolls over the last 6 months relative to the more interest-rate sensitive goods-producing industries (mining and logging, construction, and manufacturing). We are seeing a notable employment decline in the information industry, as tech companies reduce headcount amid pressures on margins.

Investment implications

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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