Investment Strategy Brief:
Earnings: Riches to Rags

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede. 

Earnings season is in full swing this week, as investors continue to digest a flurry of reports for Q2. With over half of the S&P 500 reporting thus far, the blended year-over-year earnings growth estimate for the index, which combines actual results with consensus estimates for firms that have yet to report, currently sits at -7.5%. Some of the sectors leading this decline include energy and materials, which are facing tough annual comparisons after last year’s surge in commodity prices set the bar so high. 

If all unfolds as expected, this will mark the third consecutive quarter of declining profits, extending an earnings recession that began late last year. However, where things go from here is a little less certain. Only a few months ago, analysts were expecting mid-single-digit earnings growth to return starting in Q3. However, that optimism has faltered, as expectations are now roughly flat to start the back half of 2023. Persistent profitability headwinds do not yet appear to be dissipating, setting the stage for further weakness ahead. 

Inflation has actually been one of those headwinds. A moderating CPI has been a welcome sign to the Federal Reserve so far, but its not uncommon for profitability to falter when inflation falls. Companies tend to lose their pricing power during these periods, which affects revenues. In addition, sticky costs like wages could continue to put pressure on profit margins. Accordingly, the S&P 500’s gross profit margin is expected to contract further in Q2, which would mark the 6th consecutive quarter of year-over-year margin contraction. 

This is important for investors, because growing the earnings base is a key component to generating returns in equities. However, it just hasn’t seemed to be very important this year. Total returns can basically be broken down into three drivers: 1) how much earnings are growing; 2) changes in how much investors are willing to pay for those earnings; 3) dividends. Despite the fact that earnings estimates have been falling all year, markets have rallied entirely due to ever higher valuation multiples, such as price-to-earnings ratios. While it’s worked so far this year, this trend is not sustainable long-term, especially as this year-to-date rally has seen U.S. large cap stocks return to pretty notable premium valuation levels. Valuations can’t just keep getting more expensive ad-infinitum. If investors are to expect further meaningful gains in equities, earnings are going to have to hold up their end of the bargain.
 
But as recession continues to threaten a broad-based downturn on the horizon, earnings are at risk of doing just the opposite. Yes, earnings have already begun a decline, but so far they have not yet fallen to levels consistent with past periods of recession in the U.S. On average, going back to the early 1900s, corporate earnings have fallen by 15% on average during recessions. Applying a 15% haircut to the peak level of actual earnings in 2022, it appears that earnings have further room to fall if and when a recession becomes a reality. The prospect of further weakness in earnings and still-premium valuations are material risks for equities going forward and continue to warrant a defensive posture in portfolios. 

So to summarize, Q2 is shaping up to be another negative quarter for S&P 500 earnings. If earnings reports keep the index on that track, this would be three consecutive quarters of profit contraction amid an ongoing earnings recession. While normalizing inflation may be a good thing from the Fed’s perspective, it’s not necessarily a good one for profits, as margins typically take a hit when companies lose pricing power and their costs prove sticky. 2023 has so far been a year driven by an increased willingness to pay ever higher valuations for equities, to the point where material further gains will likely need to be more forcefully driven by earnings. But the prospect of recession on the horizon suggests that earnings could be at risk to do just the opposite in the near-term, warranting a defensive posture in portfolios. 

Thanks for listening! And please don’t hesitate to reach out with any questions. 

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