Brighter prospects ahead

Markets achieved a trifecta of good news in 2023: an economy that not only avoided recession but reaccelerated, meaningful progress on disinflation, and the Fed pivot markets had been impatiently waiting for for over a year. The S&P 500 notched 26% gains for the year. On the other hand, profit growth rounded out a dismal year, likely ending 2023 roughly flat. Yet, expectations are optimistic for 2024, with analysts expecting profit growth of 11%. However, while margins may stabilize, investors should heed gloomier commentary from company management and carefully watch for a potential slowdown in revenues.

Thus far, 65% of market cap has reported earnings, with the current estimate for 4Q23 S&P 500 operating earnings per share (EPS) at $53.05. If realized, this estimate represents 5.3% y/y growth and q/q growth of 1.5% q/q.

Despite operating earnings tracking another quarter of modest growth, the divergence between operating earnings estimates and pro-forma earnings estimates persists. Current 4Q23 pro-forma estimates are tracking declines of -0.1% y/y and -9.3% q/q, with margins receding to 11.4% from 12.6% in 3Q23. Overall, 2023 pro-forma EPS estimates are set to decrease -0.1%, with revenue growth contributing 3.1 percentage points, margin growth subtracting -3.0 percentage points, and buybacks subtracting -0.3 percentage points.

It can be useful for investors to monitor both measures, as operating earnings are unadjusted and therefore tend to be a better indicator of “economic profit,” while the market prices off pro-forma earnings, which are therefore more useful to explain market moves.

Defying an overwhelming chorus for recession in 2023, economic activity remained robust, supporting revenue growth. Real GDP increased 3.3% q/q saar in the fourth quarter, marking six consecutive quarters of above-trend real GDP growth. In addition, revenues were also boosted by favorable FX conditions, as the U.S. dollar weakened 3.4% y/y on average during 4Q. Nevertheless, higher wages and inflation coupled with supply chain issues stemming from geopolitical turmoil have kept costs elevated and weighed on margins.

These dynamics have been echoed in earnings and revenue surprises, with only 68% of companies beating on earnings (vs. 72% on average) but 55% of companies beating on revenues (vs. 52% on average). This highlights the continued strength of revenues over margins, a dynamic which may begin to flip in 2024 as revenues are confronted with disinflation and a moderating consumer.

Growth sectors expected to lead the pack

From a sector standpoint, the growth sectors are likely to produce most of the profit growth, while the cyclicals may contract. Information technology and communication services should benefit from expense management, AI capabilities, and demand for software, while consumer discretionary should benefit from a robust consumer and improving inventory dynamics. On the other hand, slumping manufacturing and lower oil and natural gas prices may weigh on energy, materials, and industrials, while financials face headwinds from one-time FDIC charges and peaking net interest margins.

Financials have been largest laggard in terms of earnings growth in 4Q. The sector is currently projected to see pro-forma earnings decline 23.4% y/y. Results within the sector have been dominated by weaker- than-expected earnings among the banks, which were acutely hampered by FDIC charges related to the regional banking crisis in early 2023. Looking at the 10 largest banks by asset size in the S&P 500, the FDIC charge amounts to about $11.7 billion, which equates to 8% of net revenues.

Apart from the FDIC charge, results were also marked by weakening fundamentals. Net interest income has decreased from its highs recorded in 2022, as deposits re-price higher and loan growth remains anemic. The decrease in net interest income has been more severe for the regional banks, as non-interest-bearing deposits roll off. Regional banks benefitted from lower deposit costs over the last two years; however, with interest rates now meaningfully higher, net interest income among those same banks are the most vulnerable. As per management commentary, net interest income will remain weak in 2024 and likely trough in back half of the year, with exact timeline dependent upon the Federal Reserve’s actions. Separately, credit quality continues to weaken and move toward pre-pandemic levels. As such, provisions for credit losses increased again, with most of the cash put aside attributed to losses in office commercial real estate.

Consumer discretionary and consumer staples are projected to see positive earnings growth yet again in 4Q23 on the back of strong consumer spending, which also continues to drive real GDP growth. Consumption increased notably in food services and accommodation, pharmaceutical products, and recreational goods and vehicles. In addition to the macro tailwinds, company-level results so far have been marked by the successful clearing of bloated inventories, cost management, resilient pricing power, and margin expansion. 

Information technology and communication services seem set for a strong quarter, with EPS in both sectors currently tracking pro-forma earnings growth of 18.8% and 40.3% y/y, respectively. Within information technology, continued headcount and cost management along with strong demand for digital and AI-related capabilities should support software earnings. Results in hardware have been more mixed. While increased investment in AI has driven demand for more advanced semiconductor chips, a decline in global PC shipments, slower manufacturing activity, and a decrease in auto demand have weighed on sales of older chips.

Crude oil and natural gas prices decreased 5.0% and 51.9% y/y on average in 4Q23, respectively. As a result, energy is tracking a y/y decline in earnings. Similarly, falling crude and intermediate input prices and weak manufacturing PMI readings in 4Q will likely weigh on results in materials, which is forecast to see earnings contract by 22.3% y/y. In contrast to its cyclical peers, industrials are projected to see only a slight decline in earnings due to strong results among in the aerospace and defense, airline, and commercial services industries, although tougher comps going forward could limit future earnings growth.

Magnificent 7, revisions, and market cap: What to expect in 2024

In 2023, 68% of S&P 500 returns were attributable to multiple expansion, leaving valuations somewhat rich. In 2024, profits, which are projected to grow by 11%, should be a key determinant of returns.

Last year, the Magnificent 7 essentially drove all the S&P 500’s returns and profit growth, with profits up an estimated 29% in the Magnificent 7 in 2023 compared to profits contracting 4.8% in the rest of the S&P 500. This year, that leadership should broaden out, with an estimated 3.7 percentage points of the overall 10.9% profit growth coming from the Magnificent 7 and 7.1 percentage points coming from the rest of the S&P 500. However, to achieve this level of profit growth, the Magnificent 7 would need to grow EPS 21% this year after growing 29% last year, a high but not insurmountable hurdle. Last year, Mag 7 EPS rebounded after declining 1% in 2022, and profits surged on developments in AI. This year, the bar is higher for profit growth given last year’s results, and while AI may become a staple of these companies’ profitability, it could be difficult to replicate last year’s growth rates. In addition, the rest of S&P 500 profits would need to grow by nearly 9%, which is not unreasonable after 2023’s contraction in profits, but pressures on revenues could present headwinds as the economy’s above-trend growth rates fade and disinflation continues. Therefore, there is some downside risk to the consensus estimates for earnings.

Still, consensus 2024 EPS estimates have remained reasonably steady at 11% since the beginning of the fourth quarter. However, as more companies publish results and guidance this earnings season, these estimates may deteriorate. So far, 17% of reported companies have revised their EPS guidance for 2024 upward, while 34% have made downward revisions and 49% have maintained their projections.

Along the market cap spectrum, mid-caps are expected to post 8% y/y EPS growth in 2023 and 2024, while small caps are anticipated to rebound from profit declines of 10% in 2023 to 23% growth in 2024. However, estimates have only been revised down slightly for large and mid-caps for 2024, while small cap estimates have already been revised down 9% in the last three months.

Investment implications

Although profits should experience healthy growth this year, there are downside risks to double-digit earnings growth as the economy slows back to trend. In this environment, we continue to prefer quality, which suggests large and mid-caps over small caps, and diversification within large caps to maintain exposure to the Magnificent 7 but also ensure adequate exposure to the rest of the S&P 500 as profit leadership broadens out. 

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