Earnings season surprises: is the equity rally sustainable?

By Axelle Pinon, a member of the investment committee at Carmignac.

Investors have been positively surprised over the last two earnings seasons with published results having been “better than feared”. This echoed the overall resilience of the US economy, which continues to surprise equity markets in the face of cautious earnings expectations. However, when we look further into the coming months, there is a sense of caution. 

Since the beginning of the year, stock markets have witnessed a remarkable trajectory, and what started as a narrow bear market rally driven by seven stocks, turned into a broader one recently. 

The deflation trend has put a ceiling on long-term interest rates, leaving room for some multiple expansion: the 1-year forward price/earnings ratio for the S&P 500 went from 17x to 20x in seven months. 

Now, beyond valuation expansion, the earnings performance driver needs to join the party. 

Can earnings offer additional support for the equity rally to continue?

Quarterly profits from S&P 500 companies are expected, by the consensus, to drop between 6 and 8% from last year (mostly driven by energy and materials). But what matters is the forward-looking commentary. The consensus still suggests a rebound in earnings as soon as Q3, which will keep gaining traction into 2024. Therefore, it’s worth paying attention to companies that provide moderate forward guidance, even if it's not negative. If such stocks experience significant declines, it might suggest that expectations were too high, potentially leading to challenging times ahead. 

For the full year 2023, the consensus expects a bit less than 1% of earnings growth, driven by H2 numbers. But when we look in detail, this figure reflects mostly pain in some sectors (with energy, materials, and healthcare expected to be negative this year).  

These 2023 EPS expectations have been unchanged for a few months, so in order to justify the recent multiple expansion, H2 2023 and 2024 figures need to move higher. In our view, this scenario seems unlikely, as we should see a synchronized economic slowdown due to the growing impact of tighter monetary policy in the real economy. So far, the effect of rate increases on companies’ earnings has not fully manifested and despite wage growth, companies’ margins remain at a very high level. 

Caution and selectivity are the order of the day.

Topics under close scrutiny

AI & Big Tech: hype or real revenue opportunity? 

As seven companies have been driving most of the S&P 500 performance, all eyes will be on their ability to deliver on the earnings front to match their multiple expansion. 

These companies have very various profiles: Nvidia and Meta have seen upward revisions of earnings estimates for 2023 since the beginning of the year, but investors left their expectations broadly unchanged for the other five, offering no earnings support to justify this strong outperformance. Despite these revisions, the Big Tech firms are still expected to post among the best earnings growth of US companies for Q2 2023. One small miss could lead to a huge disappointment for markets, as proven by Tesla and Netflix already. 

The revenue opportunity linked to AI is, once again, the main focus. The last earnings season was all about how often “AI” was mentioned during earnings calls. This time should be more “show me the money"... Companies with the nearest path to AI revenues should be the ones receiving the best rewards.  

For now, Microsoft seems the nearest-term beneficiary of the proliferation of AI. This is based on its controlling stake in OpenAI, which can ideally be utilized within its Azure cloud infrastructure, allowing enterprises to capitalize on AI initiatives, and its plan to incorporate an AI “copilot” into its Office365 software suite – with subscription prices being 1.5x higher than their historical suite. 

Beyond AI, efficiency remains a requirement in 2023. For instance, Meta’s strong performance year-to-date has been driven by a management pivot from heavy spending to aggressive cost-cutting while de-emphasizing the metaverse strategy. All-in-all regaining some of the credibility among investors that had been lost in recent years. Going forward, emerging growth drivers should gradually become the focus of attention again, but not at all costs as has been the case over the past decade.

The European deceleration

In Europe, the earnings contraction over the quarter is estimated to be around 12%. This is worse than in the US, notably due to the weakness of the manufacturing sector. 

For 2023, earnings growth is still expected to be in slightly negative territory. However, consensus expects a recovery in 2024. Risks of downgrades over the next weeks regarding the end-of-year/next-year outlook are clear as PMIs are already in contraction territory and the stronger Euro could hurt big exporters. 

The luxury sector will matter, as it has been one of the main contributors to the performance of European indexes this year, supported by a more benign rate environment and China’s reopening. Therefore, this earnings season should be an indicator of its ability to pursue outperformance for the coming months. The sector has seen positive revisions from the consensus over the last weeks, setting the bar higher, with the risk of China not making up for weakness in the US market, as seen with Richemont.  While the short-term outlook could be more challenging, mostly due to an issue of “actuals vs expectations”, this could lead investors to a widening of the gap between luxury sector winners and losers. 

Consumer squeeze

Economists continue to obsess over the health of the consumer to determine how deep the impending slowdown could be. 

So far, customers have generally been able to stomach higher prices as companies have passed on elevated costs, allowing some margin protection. But in some segments, like retail, concerning trends are developing beneath the surface, most notably in case of rapid deceleration in wage growth, which, could become a risk. The key question going forward is how disinflation and an economic slowdown will impact spending, along with the risk of price wars developing.