Top takeaways

What will investors be listening for on Conference Calls?

Broad Economy

Inflation

Inventories (Industry dependent)

Labor

Capital Allocation

Financials

Other

Setting the stage - A look back at Q1

The new year began on the heels of the very strong rally in the final months of 2023 as equity markets began to sense one of the most aggressive tightening cycles in history was nearing an end. The S&P 500 rallied >15% over the final two months of the year without a down week, closing out 2023 up nearly 25%. In those final two months the rally broadened out with the S&P 500 equal weight, S&P 400 midcap index and the Russell 2k all ending the year with mid-double digits returns after being lower at the end of October. Treasuries also rallied sharply with the 10yr yield falling >100bps, breaking back below 4%, and reversing pretty much all of the move higher seen in the previous six months. Not only did markets sense the end of the tightening cycle, but investors also began to price in over 150bps of rate cuts starting in March.

The year got off to a bit of a choppy start following a very strong jobs report and slightly hotter than expected inflation data but once the S&P 500 hit a new all-time high in the back half of January there was no looking back with the S&P 500 ending the Q1 up ~10%. In some ways Q1 was very similar to the previous quarter. Stocks continued to move higher with breadth expansion. Some of the themes remained consistent - like the AI optimism and seemingly insatiable related infrastructure spending.

However, some things did change. There were conflicting pieces of economic data and questions around signaling given large revisions and seasonal adjustments. Overall that data continued to point to a resilient labor market despite a steady stream of layoffs announcements in the opening months of the year. The “last mile” of the disinflationary process is proving to be difficult. This has caused Treasury yields to reverse course and after yesterday’s March CPI report 2-year yields are approaching 5% again while 10yr yields are back over 4.5%. During the quarter market expectations for rate cuts have moved into alignment with previous Fed projections, but given the backdrop the case for rate cuts is getting harder to make.

Valuations have moved higher over the last year which puts the onus squarely on earnings growth to drive gains going forward.

The big picture

The setup coming into this quarter is different than what we’ve become accustomed to recently. Over the previous few quarters there have been large negative revisions to earnings estimates which lowered the bar for companies to clear. This quarter, revisions have been much smaller despite a higher-than-average number of companies issuing negative guidance.

In recent quarters a major theme has been the focus on cost cutting and operational efficiency improvements. This coupled with the resilient economic backdrop should help the bottom line this quarter. However, given the strong equity market returns merely beating the estimate may not translate into stock gains and this makes stocks susceptible to significant downside should there be a misstep. In recent quarters large gains have been reserved for situations where the company not only beat estimates but also raised guidance. Given the amount of economic and geopolitical uncertainty should a company beat estimates, it would not be surprising for management teams to take a cautious approach by leaving guidance unchanged to build in some buffer for the remainder of the year.

In Q4 profit margins fell 1.5% from the previous quarter to 10.7% the lowest level since Q2 of 2020. However, some of that decline is misleading as margins in the financial sector fell to 12.6% from 17.7% in the prior year, which was also 4% below the 5yr average. I believe this was partially due to the FDIC special assessment charges related to the 2023 bank failures. For the broader index analysts are looking for margins to rebound back to 11.5% this quarter, which would be in line with the 5-year average.

That being said, we can see pressures building. Companies have been able to hold margins with price increases during the previous bout of inflation but passing on those costs has become harder as consumers have started to push back. In addition, we have started to see commodity prices and some logistics costs moving higher. The impact of rerouting goods related to the Red Sea and the Baltimore Port are not yet fully known. The aforementioned focus on cost cutting and operational efficiencies should help to offset some of these headwinds.

AI has been all the rage and once again infrastructure related spending is expected to remain very strong, but expectations are already sky high. Last quarter we did start to see the impact of this spending broaden out into other pockets of the technology sector beyond just chips. Broadly investors will be listening to calls for insight into company AI strategies and will be looking for tangible evidence that this spending is/will have an impact on their businesses. We have started to see more press about this is impacting supply chain management and industrial processes.

The sectors that have been most impacted by the AI optimism contain the mega-cap tech companies (info tech, consumer discretionary and communication services). Below is a chart of the sector level YoY EPS growth rates and you can see last year they were the primary drivers of growth but earnings growth rates in other sectors are starting to close the gap and energy/materials are expected to be much less of a drag this year.

The economic backdrop has been reasonably strong and with signs that global manufacturing may be turning a corner, investors will be listening closely to conference calls for confirmation. As you can see from the chart below there tends to be a high correlation with these turning points and earnings inflection points. If this does in fact come to fruition there could be further upside in cyclical sectors.

One area that has started to show some more cracks has been the consumer. For some time, companies have highlighted that consumers at the low end of the income curve have been feeling the pressure of inflation but at the end of the last reporting season (which was literally weeks ago) there were more signs that the high-end consumer is starting to feel the pinch. This will be something to pay attention to as we move forward, and it will be interesting to hear how trends are shaping up as confidence may once again get shaken as hopes for rate cuts fade away.

As per usual financials lead us out of the gate and given their unique vantage point within the economy, they may be able to shed some light on the state of the consumer. Lending activity is expected to remain tepid and the recent rise in yields will not help that dynamic. Investors will be looking for any signs that credit metrics are starting to deteriorate. Fee income is expected to remain solid given strong asset market performance. There was a pickup in capital market and investment banking activity in Q1 and investors will be looking for commentary suggesting this will continue in Q2 before heading into the summer and elections in the fall.

In Q4 there was a big rebound in executed buybacks while dividends continued to move steadily higher. Thus far in 2024 we’ve continued to see companies increasing their shareholder return programs with analysts projecting ~$900B of executed buybacks which is still below the peak of $950B in 2022. One question is whether the higher cost of capital and other capex spending needs will impact this going forward. Not to mention the fact that equity markets have moved sharply higher so companies aren’t getting quite as much bang for their buck.

It doesn’t feel like there is a whole lot of controversy heading into this earnings season. At this point bears have been forced into hibernation given the persistent rally, so calls for an earnings downturn have quieted. As markets have been adjusting expectations for rate cuts this year, we have made the case that markets will tolerate a higher interest rate and inflation backdrop so long as that is being accompanied by strong economic growth and a resilient earnings. There is still a lot of uncertainty but with measures taken over the last few quarters it does seem that companies have positioned themselves to weather a storm should it arise but also seem ready to take advantage should the economy continue to surprise to the upside.