Over the first quarter, equity markets had to face the fickle nature of investors: the move from a goldilocks scenario to a no-landing, to the final conclusion that recession is the most likely outcome. As this earnings season kicks off, the focus will be on finding clues as to the potential impact of the slowdown. This will allow investors to re-assess each company’s fundamentals in light of this new environment, providing key guidance as to its long-term performance.
Our key assumptions are:
- Quarterly profits from S&P 500 companies are expected, by the consensus, to drop by 7% from last year. Therefore, negative surprises should be limited. So far, this has been confirmed by the first set of earnings that have surprised me positively. Most of the big US banks posted solid results despite March’s turmoil. Until now, these earnings have underlined the resiliency of the US economy. However, in the future, we expect the benefits gained from higher interest rates to moderate and bad loans to increase as demonstrated by the additional reserves big banks set aside. Indeed, the impacts of an unprecedented monetary tightening cycle and worsening macroeconomic conditions could start to be felt not only by banks but also by the broader equity market.
- Earnings per share (EPS) forecasts for full-year 2023 have already come down considerably since their peak last year. Despite these downgrades, the current consensus still suggests a rebound in earnings as soon as Q3, which will keep gaining traction into 2024. This scenario is not compatible with the fact that many investors are predicting a US recession by year-end. So, while this quarter might not see many negative surprises, investors should brace for estimate cuts to accelerate further in the coming quarters.
- From a sector perspective, as earnings revisions have been deteriorating across the board, the biggest drop in terms of earnings growth is expected in energy, materials, healthcare, and to a lesser extent, IT. As the effects of tighter credit conditions are materializing in the real economy, both consumer and corporate demand could suffer.
Economists are scrutinizing the health of the consumer to determine how deep the impending recession could be. So far, customers have generally been able to stomach higher prices as companies try to pass on elevated costs but the picture could change with different segments of the market faring better than others:
- Luxury goods: The Chinese consumer is back, and the luxury sector is one of the main beneficiaries. The end of the zero Covid policy has been a strong tailwind for LVMH and Hermès which reported outstanding figures recently. For these firms, the Chinese consumer is offsetting the first signs of a US slowdown. And as the US slowdown gains traction, further acceleration in Chinese demand should counterbalance the effect on earnings, playing in favor of the sector.
- E-commerce: After a very challenging year in 2022, companies like Amazon should see their retail divisions under less pressure as cost reductions and price increases should pay off in the coming months. In addition, the post-Covid digestion phase is drawing to a close: the penetration rate should return to its pre-covid pace, offering a long-term growth tailwind to the sector. The biggest threat for Ecommerce remains recession; however, on a relative basis, the segment should resist better than physical retail thanks to market share gain.
- Retail: While the health of the US consumer is broadly OK (employment is still solid, wages are growing, and savings are above pre-pandemic levels), some concerning trends are developing beneath the surface, most notably the rapid deceleration in wage growth, which, if it continues, could become a risk for the second half of the year. Therefore, we think that the set-up for retail remains globally unfavorable in the near term, despite a resolution of inventory issues.
Unlike last year, despite the volatile market environment, the technology sector managed to regain its credentials in the heart of investors, on the back of cost-cutting measures, the disinflation trend, and lower rate expectations.
To understand if outperformance can last, several elements can be watched:
- As investors are preparing for a recession before the end of the year, all eyes will be on the ability of Big Tech to resist a sharp deceleration in the global growth trend.
Tech companies were quick to mention the first signs of economic slowdown. During last quarter’s earnings season, several tech companies like Amazon, Microsoft, and Google mentioned a slowdown in IT spending as they sought to optimize their cost structures in order to face a weakening macro backdrop. Alphabet and Apple also warned about a slowdown in consumer spending and advertising. Therefore, earnings expectations came down a lot, leaving room for positive surprises.
- Cost-cutting measures have accelerated over the last months as Big Tech increased its focus on Return on Investment to adapt to the end of the ultra-low-rate era. This should be an additional support for the coming months.
- AI seems to have become a genuine trend rather than a fad (like the Metaverse, Internet of Things, and Autonomous Driving might have been). Most of the major tech players are in, and market participants will closely watch any actors that might have missed the opportunity to win control of the industry’s “next big thing”. Compared to previous trends, the game changer is that the revenue opportunity linked to AI could come up very quickly, as illustrated by Microsoft’s ability to have several use cases already. Cloud infrastructure and compute power players could see also opportunities building up.