Indeed, markets are now pricing a 75% chance that the Fed will deliver a February rate hike of 25 basis points, down from 50bps in December and 75bps in the four preceding meetings.
But we think that US earnings have yet to fully reflect the impact of last year’s 425bps of increases, and we expect that the upcoming 4Q corporate reporting season will provide a reality check.
We expect 4Q earnings growth to stall. Earnings headwinds—an aggressive Fed, a normalization in demand for goods popular during the pandemic, a stronger USD, and higher costs because of more expensive labor—have become strong enough for us to expect no growth in S&P 500 4Q earnings per share compared to the same period last year. Our flat EPS estimate also masks wide sector divergence with only three sectors looking poised to produce earnings growth in the quarter. Excluding the energy sector, EPS will likely decline by 4.5%.
There are also some positives such as job gains, pent-up savings, and China reopening. But S&P 500 companies derive only 7% of their revenues from China. Overall, we expect a sharp slowdown in revenue growth to the 4–5%range, and a continued normalization in profit margins from higher-than-average levels last year.
Earnings recession in 2023 is likely. Our view on full-year 2023 earnings remains unchanged. Our 2023 EPS estimate is USD 215, which is a 4%decline from 2022. We believe the full-year bottom-up consensus EPS estimates look at least 6 percent too high.
Many of the key leading indicators for earnings, such as the Fed’s Senior Loan Officer Opinion Survey, are suggesting a contraction is likely. We also project earnings based on a top-down model that includes expectations for the unemployment rate, the ISM Manufacturing index, unemployment claims, and the dollar. The Fed appears to think that current high wage growth is inconsistent with bringing inflation down to 2%. It has forecast the unemployment rate to climb from 3.5% today to 4.6% by the end of the year. In addition, the lagged effects of previous rate hikes will likely keep the ISM Manufacturing index in contraction territory (below 50) for some time. Plugging these assumptions into our model also suggests a mild earnings decline for the full year.
Higher valuations suggest a sustainable rally is unlikely. Equity market valuations are higher than where they were on the eve of the last two earnings reporting seasons. The S&P 500 forward P/E is at 17.3x compared to the 15–16x range prevailing before the 2Q and 3Q reports. It is also high by historical standards. This suggests that even if results are a bit better than investors expect, the upside market potential may be somewhat limited.
Furthermore, even if the bottom-up EPS estimate of USD 230 proves correct, we struggle to justify paying a P/E of more than 18x. That suggests upside potential to 4,140 for the S&P 500, only 4% higher than current levels. At the same time, downside risks remain elevated, and stocks could fall 15–20% if the economy enters a full-blown recession, in our view.
So, overall, we think the near-term risk/reward for equities is not appealing. We believe a defensive bias remains appropriate within equities and continue to favor value over growth. From a sector perspective, we prefer consumer staples, healthcare, and energy.
Main contributors - Mark Haefele, Patricia Lui, Vincent Heaney, Jon Gordon, David Lefkowitz
Content is a product of the Chief Investment Office (CIO).
Original report - US earnings season likely to provide a reality check, 13 January 2023.