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Thought of the day

In recent weeks, equity markets have been buffeted by shifting expectations over the likely course of Federal Reserve policy rates and geopolitical factors in the wake of the Israel-Hamas war. Focus this week is set to swing back onto corporate fundamentals as the third-quarter S&P 500 earning season gets under way in earnest.

We believe the profits recession is over and the US economy is on track for a soft-ish landing following healthy consumer activity, cooling inflation, and solid growth. After three quarters of year-over-year declines, we forecast the third quarter of 2023 will bring a return to growth for S&P 500 earnings per share (EPS), with profits rising 3–4%. This compares with 0% blended EPS consensus growth forecasts, according to FactSet.

  • The macro backdrop is still supportive. The resilient US macroeconomic backdrop continues to surprise positively. As the third quarter progressed, consumer balance sheets were shown to be in better shape than previously thought, labor market strength continued, and inflation fell further. Consumer spending, which accounts for 70% of US economic activity, accelerated in the third quarter, and we believe the changes in expectations for real GDP growth from flat to 3% should provide additional support for earnings growth.
  • Earnings are being driven by mega-cap growth stocks. We believe much of the earnings improvement will be driven by the seven largest tech/growth companies, the "Magnificent 7," since these companies are expected to announce 30%-plus EPS growth. Consensus forecasts are for modest declines for the remaining constituents in the S&P 500. But beyond the worst-performing outliers, trends are improving for the average company, with the growth rate for the median expected to grow at a mid-single-digit rate. And S&P 500 earnings revisions have registered a notable improvement this year. On a net basis, analysts are modestly upgrading forward estimates.
  • Margin expansion looks set to continue. While we believe lower inflation is likely to have weighed on corporate revenue growth during the third quarter, we estimate costs cooled at a faster pace. So, we forecast profit margin expansion to continue from last year's fourth-quarter lows. Indeed, profits are more heavily weighted to goods rather than services, and the shift away from goods consumption in 2022 has been a big drag on profits over the last few quarters. But we believe the "goods recession" looks to be fairly far along and will likely weigh less on profit growth going forward.

Overall, we expect S&P 500 EPS to remain flat in 2023 at USD 220 and then rise 9% year-over-year to USD 240 in 2024

But, given our expectations for a higher-for-longer rate environment leading to slowing economic growth in the months ahead, we now think it will take a bit longer for the index to reach 4,700. Our new price targets are 4,500 for June 2024 and 4,700 for December 2024. Even with higher rates, we expect consumer balance sheets to remain healthy, since 90% of consumer debt is with lower fixed interest rates. But there are risks to consumer spending, including the resumption of student loan repayments and higher oil prices. Furthermore, labor renegotiations, a potential government shutdown, and geopolitical conflicts add to economic uncertainty.

We maintain a least preferred stance on US equities relative to other regions, yet we think the risk-reward is becoming more attractive on a 12-month time horizon, since valuations have pulled back. We hold a neutral view globally on stocks and recommend investors focus on areas that have lagged this year's rally, such as emerging market equities.