After the slide in markets since the start of the year, most agree that valuations are a fairer reflection of the risks and opportunities in the global economy. The bigger question today is whether earnings can be sustained at their current level given the tough environment for companies. If they can’t, markets may have further to fall. As the second quarter earnings season draws to a close, can any conclusions be drawn?
This quarter’s earnings season may not have got pulses racing, but most analysts agree that it wasn’t as dismal as the economic situation might suggest. Equally, forward guidance from most companies was, if not upbeat, at least not universally gloomy and largely in line with long-term averages.
Factset data shows 75% of S&P 500 companies reported earnings per share ahead of expectations. Admittedly, expectations had come down a long way and the blended earnings growth rate for the S&P 500 sat at 6.7%, the lowest aggregate figure reported by the index since Q4 2020 (which was deep in the pandemic-related difficulties).
Many will argue that these figures are backward-looking and are yet to reflect the weakness from inflationary pressures. This is certainly true, but forward earnings guidance from companies didn’t suggest that the corporate sector is about to fall off a cliff. Of those S&P 500 companies that have issued guidance for the next quarter, 42 have been negative and 30 companies have been positive. This may sound discouraging, but it is below long-term averages – which is for 60% over five years and 67% over 10 years.
More downward revision to come
Kristina Hooper, global market strategist at Invesco, said: “Some financial services firms underscored the continued strength of the US consumer. In addition, a number of companies mentioned that the labour market has eased.”
She said that this Factset summary reflected that situation: “Across the 88 Dow Jones and mid- or large-cap consumer companies that discussed the labour market, 35 companies signalled improved labour availability, compared to only one that saw labour shortages worsening. In fact, all three of the human resources and staffing firms that commented cited improved labour availability.”
In addition, some companies even mentioned an easing of wage growth pressures.
There have been a few more downward earnings revisions since the main earnings season finished, with the median earnings per share estimates for the third quarter for all the companies in the S&P 500 Index decreasing by 2.5% from June 30 to July 28. Hooper expects more downward earnings revisions to come. However, this pressure is likely to be relatively mild.
Charles-Henry Monchau, chief investment officer at Syz Bank, agrees, saying earnings have been “soft, but not dismal”.
He says: “Earnings growth expectations for the next 12 months continue to be revised downward, with the consequence that the rebound in equities since mid-June is entirely explained by an expansion in the P/E multiple. In other words, the market has become more expensive – 18x earnings per share for the next 12 months.”
This is supported by Factset data, which shows the forward 12-month P/E ratio for the S&P 500 is 17.5. This P/E ratio is below the five-year average (18.6) but above the 10-year average (17.0).
Price hikers not being rewarded as much
James Rutherford, head of European equities at Federated Hermes, says that while the earnings outlook doesn’t look too bad, investors need to be careful about the numbers. Companies may have beaten estimates in their orderbooks, but often this has been driven by large price increases due to the inflationary environment rather than volume growth.
He adds: “A strong orderbook in isolation can be misleading and suggest a healthier demand outlook for companies than they may be experiencing in reality. Investors needs to be cognisant of this and probe management teams to understand the balance between pricing and volumes.”
He says that companies achieving volume growth are being rewarded by higher valuation multiples in the market. Meanwhile, companies whose earnings are driven primarily by price hikes are not being rewarded to the same extent.
While the picture isn’t dismal, it is mixed and there are areas under considerable pressure. Oxford Economics has sought to identify some of the winners and losers on corporate earnings. It is more concerned about profit margins in developed markets than emerging margins, for example.
It said in its most recent report: “Both our leading indicators and our top-down models point to an ongoing margin contraction over the next 12 months. This is likely to result in a mid-single digit decline in global earnings per share, even if a recession is avoided.”
It is overweight in emerging market equities where the downgrade cycle is now moderating, possibly as a result of earlier invention from central banks and the ongoing recovery in China.
It adds: “We are also overweight Japan where the weaker currency has helped to boost relative EPS momentum. A robust recovery in domestic business investment in the coming quarters should also benefit the Industrials-heavy equity index.”
Aggregate earnings are likely to come down over the next few months, but probably by a single rather than double digit percentage. However, the aggregate figure masks very different outcomes from different companies, sectors and geographic regions. Markets are likely to become more discerning on the earnings outlook from here. It could shape performance for the remainder of the year.