Despite the banking scare at the end of Q1 major US indices showed resilience ending the quarter with solid gains. However, the headlines numbers did mask some of the weakness that was occurring beneath the surface, a theme that carried through most of Q2.
Markets were still trying to make heads or tails of the banking situation as Q1 earnings season began in the middle of April. With financials first out of the gate there was some additional trepidation. However, management teams did a good job laying out the facts and suggested that consumer spending trends had not meaningfully changed. The First Republic failure during the quarter led to another round of weakness within the sector but hand holding by management teams coupled with some asset sale announcements seemed to calm nerves.
As the banking concerns began to fade the next “crisis” was just over the horizon as we moved closer to a potential government debt default with the Treasury’s X-Date looming. This never caused meaningful downside in equity markets, but the impacts could be seen in other areas like short-dated Treasuries, CDS and bond volatility gauges. As negotiations seemed stalled so did US equity markets.
The S&P 500 held up throughout the first two months of the quarter driven by the continued outperformance of the mega-cap tech stocks as the AI optimism that began in late Q1 picked up steam following blowout earnings from Nvidia. However, the breadth continued to deteriorate. Heading into June the equal weight version of the S&P 500, the Dow Jones Industrial Average, the S&P 400 Midcap index and the Russell 2k had all moved into negative territory for the year.
As had widely been expected, Armageddon was averted in the 11th hour and a deal to lift the debt ceiling until January 2025 was consummated early in June. The resolution of this man-made crisis removed an overhang from the market. This coupled with resilient economic data, signs that inflation was cooling and the Fed pausing for the first time after hiking rates at 10 consecutive meetings helped the S&P 500 break out of the ~3,800 - ~4,200 range which had been in place for much of the last year, ending the quarter up ~8% bringing YTD gains to ~16%.
Not only did the S&P 500 break out of its range, but also the breadth within the market improved markedly with broad participation across sectors and market capitalization buckets. By the end of the quarter all of the previously aforementioned indices were back in positive territory with the R2k and S&P 400 both up >7% YTD by the end of June.
Data compliments of FactSet Earnings Insight as of July 7
Ahead of the Q1 reporting season analysts had cut EPS estimates by >6% for the third consecutive quarter, which is nearly two times the historical average. The potential impacts of the recent banking scare were also unknown and weighing on sentiment. This once again seemed to appropriately lower the bar and corporate earnings proved to be more resilient than feared.
Over 75% of companies beat estimates by an average of 6.5%, up significantly from the previous quarter. Despite beating estimates EPS fell 2% YoY the second consecutive quarterly decline. Revenue growth continued to decelerate increasing ~4% YoY, which was back in line with growth rates prior to the pandemic.
Some of the potential earnings tailwinds that we had discussed - cost cutting, improving supply chains and declining commodity/logistics costs helped the bottom line. Management teams did not flag significant demand shifts during the quarter, but their commentary remained cautious. That caution was reflected in guidance. Broadly speaking, companies that did beat estimates for the quarter were not raising annual guidance which implicitly was building in some additional cushion for the remainder of the year.
Heading into Q2 earnings season the backdrop has changed. The string of historically large guidance cuts is over with estimates being cut by 3% since the end of Q1, back in line with historical averages. However, that may be a function of just how much estimates had been cut previously as Q2 earnings are expected to fall >7% YoY. At the same time major indices are trading near YTD highs so price action and sentiment may not provide the tailwind that has helped in previous quarters.
Some of the themes this quarter will be similar but with new twists. Supply chains have been improving over the last year and this has recently helped companies increase production and work through backlog. In pockets of the economy this created inventory buildups. Those bloated inventories have been worked through to varying degrees - for instance retail largely seems to be through this process while chemical companies are currently facing these headwinds. Broadly speaking now that bottlenecks have been removed the question is whether this will change inventory management decisions going forward.
Many of the bearish arguments within the market revolve around profit margins. The argument is that inflationary trends tend to be a leading indicator of profit margins and as that process reverses so do margins (see Chart). According to FactSet since hitting a record of 13.1% in Q2 of 2021 S&P 500 net profit margins fell for six consecutive quarters before bouncing back to 11.5% last quarter. This is in line with historical averages and comes following cost cutting measures being instituted in Q4 to improve efficiency. Those announcements accelerated in Q1and we’d be looking for this to continue to pay dividends in the coming quarters.
Energy and logistics costs have also fallen significantly over the last year which should continue to provide a tailwind (see Chart). However, there are more signs that the consumer is beginning to push back on price increases while wages continue to move higher.
Treasury yields also remain higher and if you believe the Fed, they will remain this way for some time. This will increase interest rate expense for companies that rely on variable rate loans or need to raise capital. However, many companies took advantage of the low interest rate environment to extend maturities and when looking across the market there is not a large impending maturity avalanche in the next few years.
The concerns about overall domestic demand and the demise of the consumer over the last year have proven to be overblown though there have been slowdowns in portions of the economy. Consumers continue to work through the excess savings built up in the pandemic but given the resilience of the labor market they continue to show a propensity to spend with the consumer wallet shifting from goods to services. However, in recent quarters there have been signs that price increases which have been propping up revenues and margins are starting to impact volumes. This is the first quarter since Q3 2020 where revenues are expected to decline.
Credit conditions are tightening but we have yet to see banks pull back significantly from lending and credit quality has not deteriorated. There is nothing in the economic data seen during the quarter to suggest that this changed. Banks will likely continue to increase provisioning and reserve builds but the focus this quarter may be more about CRE portfolios as opposed to the consumer.
As highlighted last quarter it seems there is some fatigue in calls for another significant leg down in earnings estimates. 2023 EPS estimates have stabilized at around unchanged YoY after being cut by ~12.5% from last year’s peak. The relative strength of Q1 has likely built in some cushion to those numbers, but it will still take an ~8% rebound in Q4 to achieve this target. Given the recent rally valuations have gotten a bit more stretched leaving the index trading ~20X this year’s numbers. This starts to look a bit more reasonable as investors look out to 2024 estimates which seem to be factoring in a short-lived economic slowdown and rebound. Projections are calling for a >10% increase in earnings to ~$245 leaving the index trading ~18X.
Two of the biggest surprises of this year have been the resilience of the economy and corporate earnings. However, the bar does feel a little higher than it has in recent quarters. In many cases management teams have already pulled in the reins as calls for the elusive economic slowdown continue to be pushed out. As is usually the case the focus will be on commentary about the future and guidance. Investors will be listening closely for early indications suggesting the landscape is changing. Or maybe they’ll just be surprised again that it hasn’t.