Here we are again, closing out the Q2 earnings season for the U.S. and Canadian equity markets. The S&P 500 is now over 84% complete and has seen positive surprise rates of about 80%, keeping with standard practice. As inflation has continued to be a positive for corporate earnings combined with an economy that keeps chugging along, it’s a decent earnings season. Q2 S&P 500 earnings are sitting at about $52, roughly flat with last quarter and up a little from Q2 2022.
On an optimistic note, based on current estimates, earnings are poised to start to accelerate in the coming quarters. The positive economic growth and weaker USD have made analysts remain a bit more upbeat. Of course, the big question will be the economy. There is no denying that the stock market and the economy have a very loose relationship, often moving in opposite directions at times. However, earnings and the economy have a much stronger relationship. So these estimates really come down to the direction of the economy.
So everything is looking good, right? Not so fast. These are bottom-up analysis forecasts that are, let’s just say, influenced rather heavily by individual company guidance. Companies are always pretty optimistic about the future. Even if the CFO is worried about a slowing economy, do they bake that into their guidance or rely more on what is happening today? Since forecasting the economy is not easy or accurate, most extrapolate today into tomorrow – especially if today is a good news story.
Here is where things don’t really add up. From the data above, earnings are about to start expanding at about a 10% growth rate compared to year-ago levels. Meanwhile, economist consensus forecasts for the U.S. economy have real growth of 1.6% in 2023 and slowing to 0.8% in 2024. That trend is slowing, not accelerating. Now this is real growth, meaning it is adjusted for inflation. And earnings are nominal, so inflation is actually a positive. But here, too, things don’t add up. Inflation, which you would add on top of real economic growth, is forecast to be 4.1% in 2023 and slowing to 2.5% in 2024. Add these up, and economists say nominal GDP growth of 5.7% in 2023 (1.6+4.1) and 3.3% in 2024 (0.8+2.5). That is deceleration, not acceleration.
Now this is pretty loose math. Companies have operational and financial leverage that can magnify changes in economic activity as it makes its way to the bottom line. Markets are levered. But with higher interest costs and rising wages, these leverage multipliers are likely diminishing. This is evident in corporate margins, which have been steadily falling.
Let’s throw another twist into the economist vs analyst disagreement. The economy is largely driven by consumer spending, yet the stock market is more tilted to business spending. As a result, corporate earnings are more sensitive to manufacturing and other cyclical parts of the economy, regardless of what the consumer is up to. As a result, PMI (Purchasing Managers Index) has a long history of leading the trend in corporate earnings growth. In fact, earnings growth trends in six months match pretty well with PMI surveys today (we pushed PMI to the right by six months in this chart). The bad news is PMI keeps going down, which is bad news for earnings growth.
There are other factors that influence S&P 500 corporate earnings, such as the global economy, changes in the U.S. dollar, etc. However, clearly, we are faced with a situation where consensus analysts are optimistic about the future of corporate earnings while the views from economists paint a much more tempered path forward. Who is right, and who is wrong? Only time and the path of the economy will tell. But hats off to analysts for being more correct so far in 2023.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
Sources: Charts are sourced to Bloomberg L. P.
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