Key Takeaways
- We’ve seen a recent sell-off in equities as markets adjust to interest rates looking set to remain higher for an extended period.
- The Q1 earnings season has got off to a strong start. Could earnings be a key driver of market moves from here?
- There has been a strong disparity between the ‘Magnificent 7’ and the rest of the market, but we expect there to be some broadening out from here.
- Improved margins have fueled the initial earnings recovery, but revenue growth could drive the next phase.
- We are optimistic in the near term but more cautious on our view for 2025.
Markets have aggressively adjusted to the prospect of higher interest rates for an extended period, leading to a recent sell-off in equities. With this ‘higher for longer’ narrative now seemingly priced in; earnings reports could be the key driver for the next market moves.
Several large banks have already reported and mainly exceeded expectations, beating on both revenue and earnings. However, this wasn’t enough to lift stock prices significantly due to the lack of upward revision to net interest outlooks. Similarly, Netflix surpassed analyst estimates for Q1 earnings and revenue, but disappointing future growth projections caused their share price to drop. This disconnect highlights the importance of forward-looking guidance alongside raw financial results.
S&P 500 Quarterly EPS Surprise
Source: Bloomberg and Columbia Threadneedle Investments, as at 22 April 2024
This chart highlights a strong start to the earnings season, with the 70 S&P 500 companies that have reported so far exceeding analyst estimates by an average of 10%. This significantly surpasses the historical average of 5%. Notably, US companies have consistently beaten consensus estimates for the quarter since the global financial crisis. This trend can be partially attributed to downward revisions in analyst forecasts leading up to earnings season. Often, these adjustments occur in response to company guidance provided before results are released. This ‘lowering of the bar’ helps explain why, on average, three-quarters of companies typically exceed expectations.
The consensus forecast for Q1 earnings growth has fallen in line with historical norms, dropping from 7% at the beginning of the year to 2% currently. This downward revision is primarily concentrated in healthcare, energy, materials and industrial sectors. In contrast, earnings estimates for the ‘Magnificent 7’ tech giants have been revised upwards by 6% to a projected year-over-year growth of 38%. Excluding these tech leaders, the remaining 493 companies in the S&P 500 are expected to experience negative growth for the fifth consecutive quarter, with a forecast of -2%. This second chart highlights the significant disparity in year-over-year growth between the ‘Magnificent 7’ and the broader market. We concur with the consensus view that the market will experience a broadening out this year.
Consensus Earnings Growth
Source: Bloomberg and Columbia Threadneedle Investments, as at 22 April 2024
The strong performance of the ‘Magnificent 7’ can be attributed, in part, to their expanding profit margins. These margins have grown from 16.6% in Q4 2022 to 22.8% in Q4 2023. However, it’s important to note that this growth is likely to slow down as favourable base effects fade.
While improved margins have fuelled the initial earnings recovery, we believe revenue growth will be the key driver for the next phase of the upcycle. Macro data suggests Q1 should be strong relative to sell-side estimates. There are encouraging signs for the manufacturing economy with the ISM rising above 50 for the first time since 2022. Domestic investment has picked up after a decade of underinvestment and we are starting to see the fruition of investments improving productivity. From an investor’s perspective, firms spending the most on capital expenditure and research and development have outperformed those spending the most on buybacks and dividends amid a strong economic growth backdrop.
Global growth remains strong short term, but we are concerned about significant optimism around longer-term earnings. For now, Q1 and Q2 should be strong but we hold a more cautious outlook regarding 2025’s earnings forecasts, which predict a significant 14% growth. While we are likely to see another strong quarter of earnings beats, this might not translate into strong market performance without stronger guidance.
This week, a significant chunk of the market will be scrutinised as 162 companies representing 37% of the S&P 500’s market cap report their earnings. Major players like Tesla, Meta, Microsoft, and Alphabet will be under close watch.
