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As we entered Q4 US equity markets were in the midst of a selloff that had begun in the middle of the summer. That weakness continued throughout most of October as rates hit new cycle highs following stronger than expected employment and retail sales reports, inflation data that came in a touch ahead of expectations and a couple of very poor Treasury auctions. As we approached the end of October the S&P 500 had fallen ~10% from the July highs.
In our Weekly Recap on October 27th (which ended up being the low for the market) we said, "This is the type of activity you typically see near the end of a move. We are already three months into this selloff and as we've seen in multiple instances over the last year, just as positioning gets extreme that's when markets turn. If Treasury volatility calms down along with the combination of oversold conditions, extreme negativity, the restart of the corporate buyback machine as companies come out of the blackout window and positive seasonal tailwinds could set us up for the year-end rally."
As bullish as I had gotten in that moment, I never expected to see a rally quite as strong as the one we got heading into the end of 2023. A turn in the Treasury market was the first catalyst. In its quarterly refunding statement, the Treasury announced that it would not need to issue as much debt as markets had expected and that the issuance would be skewed to T-Bills as opposed to longer dated Treasuries. That started the rally in Treasuries and was followed by a better-than-expected CPI report. Then in the middle of December just weeks after saying it was too early to begin discussing rate cuts Fed officials projected three rate cuts next year and Chair Powell said he was very aware of the risks associated with keeping rates overly restrictive for too long, a far cry from the higher for longer mantra repeated throughout the year.
In theory this significantly reduced the odds of a hard landing and financial conditions eased further causing the equity market rally to broaden out with everything from cyclical stocks, small caps and even long duration assets like biotech joining in the rally. From the end of October through year end the 10yr yield fell >100bps breaking below 4%. The S&P 500 traded higher for nine consecutive weeks, the longest streak going back to 2003, rallying ~15% over that time period to end the year up ~24%. Even more impressive was the expansion of breadth. At the start of this rally the S&P 500 equal weight, midcap index and Russell 2k were all down YTD but ended 2023 with gains in the low to mid double digits. Below I’ve included a chart to help visualize just how big of a rally this was. I also wanted to point out that the move into the end of the year left the S&P 500 essentially unchanged on a 2yr basis and the yield on the 10yr essentially where we started the year.
Data compliments of FactSet Earnings Insight as of January 5, 2024
Q4 EPS Est. cut by 6.7% since the end of September, ~2X 5/10yr avg.
Number of companies issuing negative guidance slightly above historical averages (72 of 111 negative)
The Q3 earnings season began near the tail end of the selloff. Companies were beating the lowered bar but as has been the case throughout much of the year most of those beats were not accompanied by an increase in guidance. This began the string of negative earnings revisions. At the end of September analysts expected Q4 earnings to be up 8% but those estimates have been slashed to 1.3% YoY. Recently there have also been a number of high-profile companies missing on the top line highlighting some demand weakness. However, in many of those cases the bottom line held up helped by the recent focus on cost cutting and efficiency gains. Overall, there have been a slightly higher than average number of negative pre-announcements.
Given the significant estimate cuts over the last couple of months it once again feels like the bar has been lowered enough for companies to hop over it. However, that does not mean it will translate into stock gains. Over the last few quarters, we have seen a muted response to earnings beats unless they were accompanied by an increase in guidance. On the flipside companies that missed estimates have been punished. Broadly speaking, following the recent rally and given the overall backdrop it feels like the risk is more asymmetric to the downside.
I get the sense that the aforementioned high-profile misses are foreshadowing of what is to come. During the quarter economic data continued to show resilience but pointed to a deceleration. The previously announced cost cutting measures will likely help to offset some of the topline weakness. Once again I would expect the commentary from management teams will remain very cautious. The primary focus will be on 2024 guidance.
Margins will be one of the key themes with estimates calling for a drop to 11% from 12.2% last quarter. Margins moved higher during the recent bout of inflation as companies were able to pass along those costs via price increase but that is becoming harder as inflation rolls over and customers begin to pushback which is starting to impact demand. At the same time, we are starting to see some input costs beginning to tick higher. Wage have shown some deceleration but are still elevated.
Improved supply chains and falling logistics costs have been supportive over the last year but we have started to see trucking costs stabilize. The overall impact of the situation in the Red Sea could also start to have an impact in the coming quarters as containership spot rates have been moving sharply higher and companies begin to think about alternative routes.
Over the past couple quarters companies have started to highlight that higher interest rates are also starting to hit the bottom line. Broadly speaking there is not an impending wall of maturities that needs to be refinanced as this is termed out over a number of years. Should the recent easing of financial conditions and falling interest rates hold this will help blunt the impact going forward but it will be a drag.
The higher cost of capital has started to impact capital return programs. Total shareholder returns in the 12 months ending on September 30 were down ~11%. There was a big drop in buybacks in the financial sector following the banking concerns earlier this year and impending regulatory changes. Info tech continues to account for over a 25% of all buybacks but even that sector saw a decline of ~29% over the last 12 months as cash flow is used to fund other capital expenditures like reshoring and increasing AI capabilities. Share repurchases shrink the public float, hence they help increase EPS. This also potentially removes a big underlying bid within the marketplace.
Over the last year credit conditions have tightened which is starting to impact lending. Delinquency rates have been moving higher most notably on private label credit cards and auto loans. Consumer spending has remained resilient but there are cracks beginning to show. Savings rates are being depleted and ultimate impact on the restart of student loan payments is still unknown.
As per usual financials will lead us out of the gate. With the backdrop laid out above commentary about credit quality is probably the most anticipated aspect of bank earnings. In regard to consumer credit and commercial real estate this tends to have a bigger impact on the small/medium sized regional banks so we could get lulled into a false sense of complacency early in the reporting cycle on that front.
Investors will also be listening closely to see if management teams highlight any change in the environment following the recent easing of financial conditions. This should help to alleviate some of the concerns related to unrealized losses on the balance sheet. Capital market activity is another area of interest as there has been a recent pickup in M&A activity, bond issuance and there are some green shoots on the IPO front.
Zooming back out from financials another theme this quarter will be around inventories. This will vary widely across industries. For instance, retailers have been going through the destocking process throughout the last year as they adjusted to changing consumer spending away from goods to services and this process seems like it is largely over. More recently we’ve seen a couple of semi companies cut numbers as customers cut new orders to work through built up inventory levels. Investors will be listening for clues to suggest that the destocking process is nearly over and whether there is a restocking phase in the not-too-distant future which could help drive earnings higher.
Despite all the clouds on the horizon analyst estimates are calling for an earnings inflection higher from here. Even calls for a soft landing suggest there will be a slowdown in economic activity with US GDP estimates somewhere close to 2%. It feels like a lot will need to go right to hit analyst estimates for S&P 500 EPS to be up ~12% in 2024 with revenue growth of 5.5%.
There was a similar set up coming into 2023. In 2022 S&P 500 estimates were for earnings growth to be north of 10% but as we close out the fiscal year, we’re hoping that we might hit 1%. Yet markets went higher as multiples expanded.
I get the sense that 2024 will be a choppy year filled with volatility related to growth expectations, the path of inflation, geopolitical risk and uncertainty related to elections around the globe. We might not ultimately hit the lofty growth expectations but over the last few years we have seen just how adaptable corporate management teams have been navigating through new challenges and obstacles. In the coming quarters it is possible we are heading into the eye of the storm but past the clouds the future is bright.