Better than expected

At the start of the year, investors and economists were confident that 2023 would be a challenging year for the economy, markets and corporate profits. In the event, however, growth has been better than expected, equity markets are higher and earnings have surprised to the upside. While many have expressed concern about the nature of the rally this year only being led by a few stocks, healthy earnings growth has prevented the broader market from melting down; however, as interest rates have marched higher in recent weeks some signs of weakness have started to materialize.

Higher rates should weigh on valuations, leaving earnings as the primary driver of return. With 238 companies reporting (58.8% of market capitalization), our current estimate for 3Q23 S&P 500 operating earnings per share in $55.43. If realized, this would represent year-over-year (y/y) earnings growth of 10.1%, and quarter-over-quarter (q/q) growth of 1.1%. Thus far, an impressive 71% of companies have beaten earnings estimates while only 48% of companies have beaten revenue estimates as inflation continues to slow. However, both earnings and revenue surprises have been positive, with earnings beating by an average of more than 7%. Meanwhile, and arguably most importantly, profit margins have only declined slightly, with our current estimate tracking 11.8% versus 11.9% in 1Q23.

It seems reasonable to expect that this trend will continue through the end of the year, but the combination of slower nominal growth and margin pressure should lead earnings growth to slow going forward. With the recession question still unanswered, investors would be well-served by listening to management commentaries and thinking about the potential distribution of outcomes in 2024. Markets have not necessarily liked the messages being sent; companies that have beaten earnings and revenues have seen a very modest increase in their stock price, whereas those companies that have missed have been punished severely.

Sector performance continues to diverge

3Q23 energy sector profits are currently in line to decline 40% y/y, but expected to rise q/q on the back of the recent increase in energy prices. Relative to 3Q22, crude oil and natural gas prices were down, on average, 12% and 66% during 3Q23. Relative to 2Q23, crude oil and natural gas prices were up, on average, 12% an 15% during 3Q23. Fundamentally, U.S. refiners have been hesitant to increase production due to lower energy prices over the last 12-months and a continued focus on shareholder return. Additionally, earnings in the sector have found support internationally, as firms reinvest record profits from the last 2 years into exploration, drilling and capacity. 

Like the energy sector, the materials sector is tracking a y/y operating EPS decline of 13% due to subdued manufacturing activity. ISM manufacturing PMIs have been below 50 since December 2022, with the new orders subindex failing to break 50 over that period as well. Furthermore, PPI for crude materials finished the quarter down 20%.

Industrials are set for a solid quarter of y/y operating EPS growth due to the sector’s diverse composition. Within the sector, the aerospace, defense and airline industries have led the way. Heightened geopolitical tensions and aging commercial aircraft fleets have driven sales in the aerospace and defense industries, while the airlines have benefitted from a near full recovery to pre-pandemic levels of activity. Going forward, however, the airlines noted that labor costs, along with the recent uptick in fuel costs, will weigh on full year profits. These healthy results have been partially offset by weak earnings in the transportation services industry, where sales have declined as companies focus on destocking current inventories. Elsewhere in the sector, earnings have come in better than expected among the industrial conglomerate and commercial services companies due to prudent cost management offsetting weaker sales.

Financials have so far recorded another strong quarter of profits growth. Operating earnings are currently +59% y/y due higher interest rates and better-than-expected consumer spending. However, on a sequential basis, the operating earnings are expected to decline in the sector. While higher rates have supported interest income, slower loan growth and the rolling-off of non-interest bearing deposits have pressured net interest margins. Additionally, credit costs continue to rise, with delinquencies and net-charge offs reaching pre-pandemic levels. Lastly, results among the credit card companies have continued to benefit from robust spending by the wealthiest card holders. 

Both consumer sectors are in line to see strong y/y earnings growth in the third quarter due to resilient consumer spending. As per the 3Q23 GDP report, real consumer spending increased 4.0% q/q (SAAR), with goods and services spending increasing 4.8% and 3.6%, respectively. Most companies have been focused on clearing out bloated inventories; so far, however, that has not been difficult given the strength in demand. Nevertheless, while demand in aggregate has stayed resilient, management teams have noted that consumers are focusing more on essentials and less on “big-ticket” items, with many customers also now favoring cheaper, private-label alternatives. 

Within consumer discretionary, autos were a big focus for investors. Results were mixed and outlooks from management teams were cautious, as many expressed worries about the sustainability of demand amid higher interest rates. Additionally, the ongoing United Auto Workers strike is expected to continue to weigh on production and drove many firms to revise full year guidance.

The growth-oriented sectors have had another positive quarter of earnings growth. Operating EPS in the communication services sector is currently projected to grow 30% y/y. The upside in economic activity in 3Q23 supported renewed growth in advertising, which alongside growth in subscriptions and prices increases have boosted results. Within information technology, it is best to bifurcate the sector into software and hardware. Software continues to be a hot spot, as demand for cloud and AI-related services remains quite elevated. Relative to software, hardware remains weaker. As per IDC, global PC shipments decreased 7.6% y/y in 3Q23; however, shipments did increase q/q. Overall, the information technology sector is currently tracking y/y operating EPS growth of 8%.

While the health care sector is currently tracking a y/y operating EPS decline of 9%, earnings are expected to grow by 10-11% on a q/q basis.  The sector has delivered a promising set of new products, which along with recovered utilization rates, has supported revenues. So far, 77% of companies within the sector have beaten EPS estimates. Going forward, the key will be the degree to which labor costs and capital expenditures weigh on margins.

Pricing power, higher rates and market composition

While we still view 2024 EPS as being overly optimistic, better than expected economic growth momentum going into 2024 may limit the downside to earnings growth next year. Current consensus is for operating earnings to grow 12.0%; we see operating EPS growing in the low-single digits, with the possibility of a contraction in a scenario where economic activity weakens materially. Furthermore, quarterly operating earnings could take a hit in the back half of 2024 and into 2025, as waning pricing power and rising interest costs weigh on margins.

On pricing power, while CPI has subsided, pricing power may not necessarily follow suit; academic research suggests that aggregate demand is the most important factor in pricing, with a firm’s own cost basket coming next and headline inflation coming in third. So far, the consumer has stayed resilient, but this will be tested as excess cash holdings near exhaustion.

As per the latest NFIB small business survey, net pricing plans, while still positive, have declined over the last 12-months, falling in line with net sales expectations, which are negative, and headline CPI. More recently, net pricing plans have reaccelerated, likely due to improvement in net sales expectations. The key risk going forward is what happens to the labor market alongside any slowdown in demand. If wages stay elevated and weaker demand drives pricing lower, the downside for earnings increases. At the moment, while we have seen labor market momentum ease, business are still reporting positive net hiring plans, the share of businesses with positions not able to fill is quite high and compensation costs are expected to increase.

While waning pricing power will act as a headwind to corporate profits, interest costs may not be as much of an issue as originally thought. In general, we know that monetary policy tends to impact supply side interest costs with lag, and academic research suggests that this “cash squeeze” tends to occur 6-9 months after the Federal Reserve’s last hike.

However, this research was conducted prior to the low-interest environment of the last two decades. Looking ahead, any cash squeeze from higher interest costs may not be as bad as historical episodes given that rates were low for so long; companies had ample time to lock-in favorable interest rates and are also earnings more on their cash holdings due to higher rates. Currently, interest costs as share of corporate profits are tracking around 6.7%, the lowest in over 40 years. While we do expect costs to increase, we do think this provides some cushion and could mean the subsequent cash squeeze may not be as severe.

Finally, we have received several questions regarding the difference between earnings data from S&P 500 companies and earnings of the economy as a whole. In general, we believe a decent amount of this differential can be explained by sector composition. The S&P 500 is more concentrated in manufacturing and the information industries; the economy, on the other hand, is more balanced and has greater exposure to the financial industry, as well as professional, administrative, educational, accommodation and health care services. Overall, this highlights that the economy-wide measure includes smaller, niche businesses that are present at the regional level.

Given this more diverse composition, it is no surprise that corporate profits exhibit less volatility than S&P 500 operating earnings. However, with the broader scope, corporate profits at the national level are also more susceptible to any weakness in smaller businesses, whereas the S&P 500’s quality and size keeps it insulated from such a risk.

Investment implications

We recognize that better than expected U.S. economic and profit data has raised questions about what to expect from the Fed before the end of the year. With markets viewing another hike in 2023 as effectively a coin flip, the Fed is likely to remain data dependent. Interestingly, Powell added a notable comment during the Q&A portion of a recent speech, stating that “I think the evidence is not that policy is too tight right now.” It feels like the risk to Fed policy remains to the upside.

This means that investors should, at a minimum, expect slower growth in 2024. As such, we maintain a preference for large caps over small caps, particularly as smaller companies tend to leverage floating rate debt from a financing perspective. We also have a slight preference for value relative to growth; dividend payers and high cash flow companies are attractive, although we are sensitive to valuation. Finally, energy looks interesting given expectations for limited increase in supply against a backdrop of healthy demand, and we would be inclined to add to mega cap technology names if valuations begin to look more reasonable.

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