Bank stocks rallied Friday on the “not as bad as feared” narrative. But investor caution is warranted, in CIO's view, for a few reasons. (UBS)

Banks kicked off earnings season on Friday, and while the early reporters have not seen any signs of deterioration in economic conditions yet, the likes of JPMorgan Chase are setting aside more reserves in anticipation of a mild recession. We expect more of that cautious tone from other sectors as well, as companies battle multiple earnings headwinds—Fed rate increases, normalization of pandemic demand, and higher costs, particularly for labor.

4Q earnings to fall flat
We expect S&P 500 4Q earnings per share (EPS) to be unchanged versus the previous year, the slowest growth in two years. What’s more, there is likely to be a sharp divergence in sector performance, with only three sectors expected to post positive growth. Excluding energy, we expect EPS for the fourth quarter to contract by 4.5%.

We expect management guidance for the first quarter of 2023 to be somewhat mixed. Consumer spending, especially on services, remains strong given the robust labor market. Other alleviating factors include the reopening in China (although China accounts for only 7% of S&P 500 revenues), an improving economic picture in Europe amid falling energy prices, improving supply chain cost pressures, and signs that the dollar may have peaked. But areas like enterprise tech spending, housing, and goods consumption are likely to be soft.

Bank guidance not as negative as feared
Banks offered our first peek at the earnings picture on Friday. Major banks that have reported so far, including JPMorgan Chase, Bank of America, and Wells Fargo, have beaten expectations on the back of higher interest rates, benign credit, and relatively flexible expense management. Weaker fee income from investment banking, equity and debt capital markets, and mortgage banking was offset by lower credit costs, higher loan growth, and stronger net interest margins.

Management tone also wasn’t overly negative. JPMorgan and Bank of America both have a “mild recession” baked in to their central case. Delinquencies appear to be normalizing from the pandemic lows. JPMorgan set aside additional provisions for loan losses due to both robust credit card loan growth and deterioration in the management’s base case macro assumptions.

Bank stocks rallied Friday on the “not as bad as feared” narrative. But investor caution is warranted, in our view, for a few reasons.

First, most banks are guiding toward slower net interest income growth this year as rates on deposits will have to rise in response to higher interest rates.

Second, credit has remained benign with loss levels still running lower than pre-pandemic levels. Clearly, consumer and business balance sheets have held up for longer than expected, but tightening financial conditions and higher unemployment could raise credit costs in 2023.

Third, capital levels have improved as banks slowed repurchases to boost regulatory capital in the second half of last year. While buybacks could resume this quarter, they will likely be more muted, thereby dampening the potential benefit to EPS growth and profitability.

Finally, it is still early in the reporting season, and there is still risk of negative surprises in the coming weeks. Regional banks may see more deposit pricing or flow pressures, while credit card companies might see more credit cost pressures, especially on the low end.

For these reasons, we recently downgraded our view on financials to least preferred.

Earnings recession likely in 2023
Overall, we do not expect fourth-quarter results to be a catalyst for a sustainable rally in equities. The outlook for earnings in 2023 remains negative. Many of the leading indicators suggest an earnings contraction is likely. We expect the lagged effect of rate hikes to keep manufacturing activity depressed for some time. Our S&P 500 EPS estimate is USD 215, a 4% decline from 2022 and 6% lower than bottom-up consensus.

Moreover, with valuations higher than where they stood on the eve of the last two earnings seasons, the potential upside is limited even if earnings are better than expected. Overall, the near-term risk reward is not appealing, in our view. Even if the bottom-up consensus is correct, the upside potential is only 4% higher from current levels. On the other hand, in a downside scenario where we have a full-blown recession, stocks could fall 15–20%. Our base case S&P 500 targets remain 3,700 and 4,000 for June and December, respectively.

What should investors do?
Within US equities, we believe a defensive bias remains appropriate. We have most preferred views on consumer staples and healthcare. We also like the energy sector, which should benefit from China's reopening, structurally tight oil markets, and an attractive free cash flow yield.

We continue to favor value over growth. Despite outperforming, value still trades cheaper than normal versus growth. Higher-than-average inflation and supportive earnings trends also favor value.

Main contributors: Solita Marcelli, David Lefkowitz, and Bradley Ball

See the original report Earnings season likely to underwhelm 17 January 2023.

This content is a product of the UBS Chief Investment Office.