What will investors be listening for on Conference Calls?
- Q3 S&P 500 earnings are expected to increase by 2.4% YoY, but excluding energy the growth rate would be negative
- Q3/Q4 estimates getting revised lower but 2023 estimates largely unchanged
- Key topics - Margins, demand, and economic uncertainty
- Capital return programs pull back from record levels
Setting the Stage - A look back at Q3
- Broad Economy
- What assumptions are built into your estimates? Have these changed recently?
- Is the company beginning to provision for higher charge-offs or tighten lending standards?
- As the economy is slowing has there been a change in spending behavior/new orders over the last few months?
- Has this differed across geographies?
- Has restocking largely run its course and will this impact demand going forward as inventories normalize?
- How are margins holding up?
- How have previously announced price increases been tolerated by the market/consumers? How are you thinking about this going forward?
- Are previously announced mitigation measures continuing to work and what additional steps are being taken?
- As shipping rates/commodities fall when should we expect that to impact the bottom line?
- Commodity/Interest Rate/FX exposure
- How has the rising USD impacted earnings/demand?
- Given the volatility in commodity markets how is the company thinking about hedging commodity exposure (either from an input cost and/or revenue perspective)?
- How do higher rates/shape of the yield curve affect your Net Interest Income/Margins?
- Has volatility in financial markets impacted your ability to hedge any of these risks?
- Supply Chain/Logistics
- Have supply chain issues continued to improve?
- Are companies changing the way they are managing either input/end market inventories?
- How do you plan on addressing inventory builds?
- Have there been any changes in labor market trends - worker availability, wage pressure?
- Is the company planning on making any changes to its labor force given the current economic backdrop?
- Capital Allocation
- What does the capital return program look like on an ongoing basis?
- Are companies changing Cap-ex spending plans?
- How are ESG issues impacting strategy?
The first half of the year was the worst start for the S&P 500 since 1970
with the index falling 20.6%. Equity markets had started to bounce off the lows in mid-June helped by very negative sentiment/positioning, a better-than-feared earnings season and hopes that inflation would roll over leading to a Fed pivot. The rally lasted about two months with the S&P trading up ~19% from the lows before stalling out at a key technical level. However, the real downside momentum kicked in at the end of August following Fed Chair Powell’s very direct and blunt speech at the Jackson Hole Economic Symposium.
In his nine-minute address, the Chairman made it clear that price stability was the central bank’s primary goal, and that the Fed would need to raise rates to a restrictive level and keep them there for some time. The unfortunate consequences of these actions would be below trend growth and a softer labor market that would likely cause “some pain to households and businesses”. This caused markets to aggressively re-price expectations for a more hawkish policy stance. Ahead of his address futures markets were pricing in a terminal rate ~3.8% but that quickly moved up closer to 4.5%. In September, the Federal Reserve hiked rates by 75bps for the third consecutive meeting, which was largely expected. However, the Summary of Economic Projections showed that Fed officials
even higher rates
than market expectations, with the committee pretty evenly split between 4.5%, 4.75% and 5%
Treasury yields once again shot up - the 2yr yield
was up >125bps in the quarter
moving above 4%
while the 10yr was also quickly approaching this level, which had not been seen since before the Financial Crisis. As had been the case for much of the year higher yields once again sent equity markets into a tailspin. Following the Jackson Hole speech, the S&P 500 closed out the quarter down in five of the last six weeks
with four of those declines >3%. This completely wiped out the aforementioned 19% rally with the S&P breaking the June lows on the final day of the quarter, ending Q3 down 5.3%
The global economy
has been slowing
as financial conditions have been tightening. The US economy has remained resilient relative to Europe, where they are dealing with an energy crisis, and China where a mix of Covid policies and weakness in the property markets have been weighing on growth. Domestically, the housing market
has felt the brunt of the pain
thus far as mortgage rates
have moved up close to 7%
, causing a sharp drop in sales. Consumer spending
has remained robust
, but this is somewhat misleading as it has been driven by an increase in credit
with revolving credit up >18% over the last year. The labor market
has also remained resilient
with the unemployment rate holding around 3.5%, though we are starting to hear a steady drumbeat of companies announcing hiring freezes or layoffs. At this point outside of some slight deceleration in some of the core inflation readings there are limited signs
. This has put central banks in a difficult spot, where the fear is they will magnify the earlier policy mistake of reacting too slowly to inflation by tightening too aggressively into an already slowing economic backdrop.
Despite the global growth concerns, earnings estimates have held pretty steady with the street currently calling for ~8% YoY growth in both 2022 and 2023. Most of the damage that has been done to equity markets has come in the way of multiple compression with the S&P 500 trading from ~21X at the start of the year to ~15.5X. Over the last two years corporate earnings have outperformed pretty much all expectations but with the gloomy economic backdrop and the recent high-profile disappointments the looming question is whether Q2 was the last dance?
Inside the Numbers*
The Big Picture
- Q2 S&P 500 earnings grew by 6.3% YoY, the lowest growth rate since Q4 2020
- 75% of companies beat analyst estimates by 3.4%
- Q3 earnings are projected to increase 2.4% YoY, however excluding energy earnings would be down 4%
- Energy (+118%) and Industrials (24.1%) helped by airlines showing the largest YoY growth
- Communication Services (-13.6%) and Financials (-13.5%) largest declines
- Revenues projected to grow 8.5%, which would break streak of 6 consecutive quarters of >10% YoY revenue growth
- 61% of companies issuing negative guidance, down from recent quarters
- Earnings estimates have declined by 6.8% since the start of the quarter
- Energy (+7%) the only sector with a positive revision
- Materials (-15.1%), Communication Services (-13.7%) and Consumer Discretionary (-13.2%) and have largest declines
- Capital return programs
- According to S&P Global S&P 500 Q2 buybacks fell ~22% to ~$220B from Q1’s record ($281B)
- In Q1 - 331 companies repurchased >$5ml down from 374 in the previous quarter (395 companies did buyback stock)
- 42.1% of total buybacks were completed by top 20 companies down from 51.8% in the prior quarter
- Q2 S&P 500 dividends up 2.1% QoQ to record $140.6B
- Total shareholder returns declined 14% QoQ to $360.2B
For the last few quarters concerns have been building that with rising labor, logistics and commodity costs companies would face margin pressures. However, this was largely offset by pricing power and strong demand and margins have remained near record levels. That strong demand is now in question as the global economy stalls and US consumers are feeling the impact of inflation and higher interest rates.
Heading into the Q2 earnings cycle, sentiment was very negative, and the street expected this to be the quarter that companies would finally begin to slash guidance. Once again, corporate earnings came in better than feared. That is not to say that it was a gangbuster reporting season like we’d become accustomed to in 2021, but we avoided wholesale cuts to guidance. For the quarter earnings ended up just over 6% YoY. The strength in energy, which saw earnings grow >250% YoY, masked some of the underlying weakness. If this sector was excluded earnings would have fallen 4%. However, margins held steady at 12.3% from Q1 and remained just below the 13.1% record seen late last year. While numbers were not getting slashed management teams did seem to get increasingly more cautious about the environment.
The setup heading into this quarter feels very similar. Sentiment is once again very negative, and the economic backdrop continues to worsen. There have been some high-profile negative pre-announcements
and early cycle earnings misses, but the number of negative pre-announcements have trailed off from the last few quarters. The common themes
thus far have been a drop off in demand, inventory levels building and continued supply chain issues
. For global companies that demand drop has been most pronounced in Europe and Asia and the continued dollar strength is weighing on results.
A combination of the pre-announcements and slowing GDP have led analysts to cut Q3 earnings estimates by nearly 7% since the end of June
. This is the largest decline since Q2 2020 and nearly twice the average 3.8% decline seen over the last 20 years. This is also bleeding into Q4 estimates but 2023 has remained largely unchanged. Energy continues to mask the underlying weakness and is the only sector that has seen positive revisions since June. Excluding energy quarterly earnings would once again be negative. The largest negative revisions have come from materials, communication services and consumer discretionary.
The themes coming into this quarter will also sound familiar with demand/inventories, margins, supply chain and the US dollar strength the key topics. Earnings season typically allows investors to shift their focus away from the macro and to company fundamentals. This will provide management teams the opportunity to differentiate from the pack as they lay out strategy and competitive advantages. However, this quarter more than most, investors will be listening to conference calls for a real-time update on the fast-changing macro backdrop. One of the early takeaways thus far is that there are disinflationary pressures building
within the system as multiple companies have highlighted bloated inventories
continue to believe earnings estimates
remain overly optimistic
and that this quarter will be the turning point that leads to a cycle of negative revisions. Time will tell if that is indeed the case. If there are guidance cuts it will be important to see how stocks trade in reaction to the news, to better understand how much is already priced into the market.
In some ways the current environment may prove to be different than past business cycles given the distortions seen coming out of the pandemic. We’ve talked about near record margins which have come during a period of significant costs pressures in most aspects of the business. One potentially overlooked factor is that companies could start to see some relief with commodity pricing, shipping and freight rates all falling. It also seems that supply chain issues are abating and if the labor market softens that too should relieve some of the pressure. These factors could help to offset some of the drop off in demand and corporate earnings may once again prove to outperform expectations.
I’ll wrap up like I did last quarter. Two lessons coming out of the 2020 pandemic were that corporate management teams were fast to adapt to the changing environment and corporate profitability was more resilient than anyone had expected. This environment presents a new set of challenges and there will be some setbacks along the way. As I’ve said for the past few quarters, I think the volatility we’ve seen to start the year is a precursor of things to come and we are not out of the woods yet. We are flying through the eye of the storm, so make sure to strap on a seatbelt and prepare for some turbulence as the Fed tries to bring this plane in for a landing.
*Data compliments of FactSet Earnings Insight
as of October 7
- Q3 earnings expected to grow by 2.4% YoY
- 5 of 11 sectors are expected to report earnings growth
- 4 sectors with EPS growth >10%: Energy (+117.6%), Industrials (+24.1%), REITs (+14.7%), Consumer Disc. (10%)
- 2 sectors with EPS declines >10%: Communication Services (-13.6%), Financial (-13.5%)
- Q3 YoY Revenue est. 8.5% YoY - dropping below 10% for first time since Q4 2020
- All 11 sectors are expected to report revenue increases
- 4 sectors with revenue growth >10%: Energy (+33.7%), Consumer Disc. (14%), REITS (+13.1%), Industrials (12.6%)
- 4 sectors with revenue growth <5%: Communication Services (4.2%), Healthcare (3.9%), Financials (+2.8%), Utilities (1.7%)
- 2023 EPS estimates: +7.9%, Revenues +4.3%
- Forward P/E Ratio 15.8 below the 5yr/10yr avg of 18.5/17.1