Key Takeaways
- Next month sees the start of the Q3 earnings season – we expect expectations to be broadly beaten.
- In the run up to earnings releases we typically see estimates revised downwards – that trend has been bucked, especially in the technology and consumer discretionary sectors.
- Earnings have fared better than many expected this year, with profit margins remaining resilient. Robust consumer spending has helped.
- We assess some of the other factors set to influence earnings from here, including higher borrowing costs.
Next month, companies will begin reporting earnings for the third quarter and we expect another strong performance with broad based beating of expectations. Much of this year's equity market gains have come from multiple expansion driven by growing enthusiasm in Artificial Intelligence, but earnings remain essential for longer-term performance and are likely to be the most important driver of stock prices over the next year.
In the US, consensus earnings estimates often decline ahead of the reporting season but then surprise on the upside when results are announced. The S&P 500 US equity market tends to see downward revisions in the two months leading up to results. This lowering of expectations, often based on company guidance prior to the earnings season, explains why, on average, three-quarters of companies beat expectations. The first quarter saw a 6% drop in consensus Earnings Per Share (EPS), followed by a 4% decline in the second quarter. Surprisingly, third quarter estimates contradict this trend of lowered expectations, holding up well as the quarter end approaches. The Technology and Consumer Discretionary sectors are driving this, with both experiencing roughly 5% upgrades since the end of July.
Earnings have fared better than anticipated this year, with profit margins remaining resilient. Margins peaked in the middle of 2021 as inflation started rising, steadily declining until the end of 2022. The expectation was that ongoing disinflation would erode margins, but this hasn’t been the case this year. Real growth has rebounded, supporting revenues even as inflation eases. Margins have bounced back over the last two quarters, resulting in seasonally adjusted quarterly EPS growth of 3% in each. When excluding the volatile energy sector and lumpy loan loss provisions by banks, EPS growth is higher in each quarter at closer to 5%.
Surprisingly, corporate interest expense as a percentage of profits has been decreasing despite rising interest rates. This is partly because most firms had extended their maturities before the rate surge. Firms with substantial cash balances are also earning interest income, offsetting some of their gross interest expenses. This benefits large-cap companies, where almost 90% of debt within the S&P 500 is fixed. In contrast, smaller-cap companies are experiencing rising interest expenses due to an equal split between fixed and floating debt. We expect corporate balance sheet health to gradually deteriorate as more corporations refinance into the higher-rate environment.
The delayed impact of significant monetary policy tightening is also visible in the US housing market. Over 60% of US mortgage holders have rates below 4%. US mortgages typically have longer terms than those in the UK, and with current mortgage rates exceeding 7%, many homeowners are staying put. Earnings calls highlight the resilience of consumer demand, making a soft landing more likely than previously thought. However, several upcoming events are of concern.
August marks the first month since February 2020 when individuals must make payments on student loans, totalling approximately $10 billion monthly. Additionally, there’s concern about excess savings, with the San Francisco Federal Reserve estimating that savings amassed during the pandemic will be depleted this quarter. An ongoing auto strike and the prospect of a government shutdown due to legislative gridlock also add to the uncertainty.
On a global scale, consensus forecasts predict flat earnings growth this year, followed by an 11% increase in 2024. Our internal earnings model forecasts a similar outlook. Commodities have weighed down earnings, with estimated 2023 growth rates of -30% in energy and -23% in materials. This disproportionately affects the FTSE 100, which is projected to have the lowest regional EPS growth at -12% this year. The recent uptick in commodity prices since June has improved UK earnings revisions. Globally, we expect the strongest earnings momentum to come from the US and Japan. The US benefits from higher profit margins and a more flexible labour market, while Japan benefits from ongoing corporate transformations.
Despite concerns about inflation and interest rates, corporate profitability has held up well, and many companies are exceeding expectations.
