The first quarter US earnings reporting season is getting underway. Companies’ results will, as always, be studied for clues as to the future direction of the equity market. Divining the lessons could be particularly challenging this time round because expectations are for first quarter 2023 earnings to have declined versus the same quarter a year ago. Uncomfortable food for thought for equity investors who would prefer positive earnings momentum.
An additional challenge (and the primary reason earnings are – again – expected to decline) is that profits are normalising after the boom following the end of the Covid lockdowns, when pent-up demand and inflation led to unusually high earnings. What the trend level of earnings should now be is still unclear. Analysts are hoping that this would have been the last quarter of negative earnings growth (if one excludes the energy sector). The same poor results from the last several quarters should then allow for much bigger gains as the year progresses (see Exhibit 1).
Basis effects – Something to anticipate?
One could question whether such a positive trajectory is reasonable.
The most recent data shows economic growth and inflation pressures remain strong: non-farm payrolls growth exceeded market expectations, the services sector purchasing manager indices are above 50, and year-on-year core consumer price inflation (CPI) has risen compared to the previous month. Particularly now that the stress from the recent banking sector turmoil has faded, there is little reason for investors to believe that the US Federal Reserve will not continue to hike interest rates. In fact, the peak rate expected for this cycle has partly recovered from the decline last month (see Exhibit 2).
Good for now – And then what?
We believe that a recession will ultimately be necessary to bring inflation back down to the Fed’s 2% target, in which case earnings are much more likely to decline than rise. The timing is unclear, but as long as equity markets see positive economic growth, they are likely to gain ground. Once the impact of the increase in policy rates becomes more evident, the mood in the equity market may sour.
Some investors have instead focused on the end of the hiking cycle as a reason to be more optimistic on the outlook for equities. We believe this is mistaken. Central banks are raising rates because growth is good and inflation is strong, factors which are positive for corporate profits. They will begin cutting rates once recession is in sight, an environment where earnings and markets typically fall. For now, however, things look good. With just 63 companies in the S&P 500 having reported, earnings growth is nearly 6%, with much-better-than-expected earnings for financials offsetting disappointing results for technology companies (as has been the pattern in the last few quarters). Surprises should remain positive, even as the actual results take a turn for the worse as more companies report.
China – Leading emerging markets?
Given the challenges facing the US and Europe, the better-than-expected figures for first-quarter GDP growth in China reinforce the view that emerging market equities should begin making up some of their underperformance of the last year.
Strong retail sales data shows that this recovery of the economy is likely to be more domestic focused than those in the past, where the global spillover was more to commodity prices through increased fixed investment.
This time it will likely be the service sectors that drive growth, as has been the pattern in other countries when economies reopened. A key international channel will be tourism, which has so far grown only slightly.