Despite increasing signs of slowing growth, corporate earnings continue to show resilience. Over the three quarters ending 2Q 2023, earnings revisions, while negative, have beat expectations, contributing to the equity markets’ ongoing buoyancy. More to the point, recent estimates reflect an even rosier outlook, with earnings revisions approaching positive territory for 3Q 2023 and beyond (see Figure 1).
Figure 1: Quarterly S&P 500 EPS Estimates
September 1, 2023
Source: Bloomberg Finance L.P.
However, data on the wider economic environment suggests less optimistic conditions may be on the way first. The compounding effect of multiple Fed rate hikes and dwindling excess consumer savings are likely to generate considerable headwinds. Additionally, inflation, while currently at a relatively moderate 3.3%, remains above the Fed’s target of 2%. Further tightening could be in the works, especially if more of an economic slowdown isn’t seen soon.
In light of this murky backdrop, Hilton explores what could be driving current earnings estimates, related market risk, and how active management could help investors better navigate increasingly uncertain conditions.
Slower Growth Expected Ahead
Restrictive monetary policy commonly works its way through the economy over time, with lags that can last months or longer. More interest rate-sensitive sectors experience the squeeze first, followed by corporate profits and employment.
Currently, the impact of Fed tightening is most apparent in housing, borrowing, and industrial production. Higher mortgage rates and auto loans are weighing down affordability, and new orders have slowed.
However, financial conditions are still relatively loose, and labor markets are only just starting to show cracks. In particular, increases in labor supply and labor force participation一and reductions in job openings一have yet to significantly impact the national employment rate, which, despite incremental gains, remains historically low at 3.8%.
Regardless of whether the Fed raises rates again, evidence of additional deceleration in employment data will be required before it declares inflation is defeated. Fed Chairman Jerome Powell said as much at the Fed’s annual economic symposium in August.
“Getting inflation sustainably back down to 2% is expected to require a period of below-trend economic growth as well as some softening in labor market conditions,” Powell said.
Consumers Are Burning Through Excess Savings
At the consumer level, conditions also appear to be deteriorating. Pandemic-induced surplus savings, which sustained robust consumer demand over the last year, are nearly depleted. As shown in Figure 2 below, August 2021’s high of $2.2 trillion has declined to just $0.27 trillion ($270 billion) as of last month. Levels are expected to bottom out by October 2023.
Figure 2: U.S. Personal Savings (Cumulative)
July 2023 vs. Pre-COVID Period
Source: Piper Sandler.
Additionally, personal spending remains on the upswing, a situation when combined with the declines in personal savings, can further contribute to stalling growth (see Figure 3 below).
Figure 3: PITLCHNG (U.S. Personal Income & Spending Month-over-Month SA)
Daily, September 20, 2021 to August 31, 2023
Note: Trend lines illustrate percentage change month-over-month.
Source: Bloomberg Finance L.P., U.S. Bureau of Economic Analysis.
What Earnings Estimates Could Be Telling Us
Despite mixed macroeconomic conditions, however, earnings estimates appear to be moving in a more decisive direction. The benchmark earnings indicator, the S&P 500 (SPX) 2023 Earnings Per Share (EPS) Estimate, is increasing一signaling possible upswings in forthcoming earnings revisions (see Figure 4).
Figure 4: S&P 500 Index (SPX) Forward-12 EPS Estimate
Daily, September 6, 2022 to September 6, 2023
Source: Bloomberg Finance L.P.
Relatedly, the S&P 500 Index Total EPS forecasts positive revisions well into 2024 (see Figure 5).
Figure 5: S&P 500 Index (SPX) Forward-12 EPS Future Outlook (Index Total EPS Year-over-Year)
June 30, 2011 to March 31, 2026
Source: Bloomberg Finance L.P.
We believe positive earnings stories could be based on a combination of factors, possibly related to expectations of cost reductions rather than top-line revenue growth. These include:
- Lower Inflation: Expected lower input costs and improved consumer confidence can boost future profits.
- Job Cuts: Companies may be anticipating workforce reductions or reducing wage growth. Over 200,000 layoffs have already occurred in several industries this year.
- Easier Comparisons Against Comparable Periods. This could apply to EPS estimates for a given period against the same period in the previous year, such as Q3 2022 versus Q3 2023. If last year’s EPS were negative or particularly low (as in 2022), more recent earnings estimates could look favorable in comparison.
The Impact on the Markets
Thus far, much of 2023’s double-digit equity returns, particularly in large-cap growth stocks, can be attributed to the optimism generated by the absence of a recession, compliant financial conditions, and expectations of an imminent Fed pivot.
That said, whether earnings estimates are grounded in the realities of the current situation, or what may lie ahead, remains to be seen. But the breezy sentiment behind positive earnings expectations has also contributed to price momentum and increasingly lofty valuations. While off its summer high of 19.1x, S&P 500 multiple expansion is still apparent at 18.2x versus February’s low of 16.4x.
This has further complicated market conditions, already contending with an uncertain macro situation and significantly declining breadth. In particular, the advent of ChatGPT and other large language models earlier this year has also fueled exuberance, pushing markets higher, led by only a handful of tech giants earmarked for AI-driven greatness. As of September 1, 2023, the so-called Magnificent Seven一Apple, Amazon, Google, Meta (Facebook), Microsoft, Nvidia, and Tesla made up 28% of the S&P 500 Index一and were responsible for 65% of the Index return.
The resulting narrowing has driven correlations between index constituents down as well as on an index-to-index basis. Year to date (as of September 8, 2023), the market-capitalization-weighted S&P 500 has beaten its equal-weighted counterpart by an unprecedented 11.8 percentage points (17.4% vs. 5.6%). Returns for the Russell 2000 are slightly better at 6.2% with the tech-heavy Nasdaq Composite Index topping 32.3% across the same period.
How Active Management Can Help
For investors, wading into uncertain market conditions such as these can pose significant risks. Given the current market narrowness and low correlations, identifying positive earnings stories with greater opportunities to deliver will be essential to generating returns and dampening losses.
As such, we believe it’s an environment that favors active management grounded in disciplined fundamental analysis and seasoned stock selection.
As active managers, we at Hilton bring extensive knowledge of sectors, industries, companies, and their particular growth drivers to the fore. Combined with our deep understanding of the broader macroeconomic context, we strive to uncover meaningful insights to help achieve investment goals. Stock selection has always been a key pillar of our investment strategies, and given our 20-plus year track record, fundamental to our success.
As always, we will stay focused on developments as they unfold and work to position our portfolios to create continued opportunities for growth, regardless of market conditions.