Maintain 2.5 Stars on US equities: Weaker than expected earnings data suggests more pain ahead

• 4Q22 earnings were less than ideal with a larger than usual share of companies falling short of expectations. Aggregate earnings growth declined as well, putting US equities at risk of an earnings recession. 

• At the sector level, only five out of 11 sectors managed to deliver positive year-on-year earnings growth led by energy (+58%), whereas communication services saw the biggest decline in earnings growth (-26%).

• Margins and earnings are still overly optimistic, and are not an accurate reflection of the state of the US economy. Expect to see more cuts and margin compression going forward.

• We maintain a 2.5 Stars “Neutral” rating for US equities given the worsening macroeconomic data and mounting earnings headwinds. Valuations are also unattractive given the limited upside available. 

• As the earnings-bond yield spread continues to compress, we recommend investors to overweight fixed income over equities. Alternatively, investors who are still keen to remain in the US equity space may want to consider adopting a quality/value tilt instead. 

Among the various factors that affect share prices, earnings is arguably one of the most important, especially when it comes to determining their performance in the long run. This can be observed through the close relationship between share prices and earnings in Figure 1. Given the significant influence that earnings has on share prices, we will be taking a closer look at the latest earnings results for US equities as the fourth quarter earnings season draws to a close. 

Figure 1: In the long run, share prices are predominantly driven by earnings 

Mediocre earnings season for US equities in 4Q22

As of end-February 2023, the majority of all S&P 500 companies have already reported earnings. Here are some key statistics. 

Among those that have already reported, only 68% reported a positive EPS surprise, below the five-year average of 77%. What is more worrying is that on aggregate, the earnings surprise percentage is only 1.2% above estimates, significantly below the five-year average of 8.6% (Figure 2). 

As a matter of fact, the earnings surprise percentage has been on a downtrend for seven straight quarters, and it is currently the lowest since 1Q20 (1.1%) when the pandemic first hit. For the recent few quarters, the earnings surprise percentage has also been much smaller than usual. This is likely because many analysts may have underestimated the impact high inflation and interest rates have on corporate earnings, resulting in overly optimistic earnings estimates and thus more companies falling short of expectations. 

Figure 2: S&P 500 Index earnings surprise percentage is at the lowest level since 1Q20

In terms of growth, the aggregate earnings growth for the S&P 500 companies declined by -4.8% year-on-year, marking the first time earnings fell in the post-pandemic era. This figure is also well below the five-year average earnings growth rate of 14.3%. Looking ahead, analysts are predicting that US equities will soon experience an earnings recession, with earnings expected to fall by -5.7% and -3.7% in the first and second quarter of this year respectively. 

Seven out of 11 sectors have reported negative earnings growth 

At the sector level, only five sectors managed to deliver positive year-on-year earnings growth, led by the energy sector which saw earnings rise by nearly 60%. ExxonMobil and Chevron, two of the largest oil majors in the US, saw their full-year net income more than double compared to a year ago after a strong fourth quarter.

The energy sector continued its stellar run amid higher oil and gas prices throughout 2022, partly driven by the Russia-Ukraine war. Aside from the conflict in Europe, rising energy demand owing to the global economic recovery post Covid-19 was met with supply constraints, leading to higher oil and gas prices. The energy sector is the single largest positive contributor to the S&P 500 earnings growth this quarter. Without the contribution from this sector, the aggregate earnings decline would be significantly worse at approximately -9.0% instead of -4.8%. 

On the flip side, the remaining seven sectors saw their earnings slide into the red. The communication services sector is currently the worst performer of the lot, with a year-on-year earnings decline of more than -25%. Poor results from big tech names, such as the likes of Meta and Alphabet, played a significant role in the sector’s lacklustre earnings. US tech firms have collectively laid off close to 140,000 workers since the beginning of 2022 in an effort to cut costs amidst a cooling economy and a looming recession.

Figure 3: S&P 500 sector earnings growth breakdown

Financials, the third largest sector of the S&P 500, was also one of the main contributors to the overall earnings decline. Even though banks generally perform well in an environment of higher interest rates, the drop in mergers & acquisitions and initial public offering activity due to the weakening economic outlook has led to lower investment banking revenues. In particular, Goldman Sachs, whose investment banking fees make up the majority of its revenue, reported earnings that were nearly -40% lower than the consensus forecast as deal volumes plunged.

The increasing likelihood of a recession has also prompted many lenders to be more cautious, setting aside more funds to cover potential loan losses. Together, the big four US banks (JPMorgan, Bank of America, Wells Fargo, and Citigroup) have USD 6.2 billion in loan loss provisions as of 4Q22, nearly three times the amount compared to the beginning of the year. Higher loan loss provisions reduces earnings (Figure 4). Even though reversions in loan loss provisions may provide an earnings tailwind, they are not likely to occur in the near future given the weakening economic outlook. 

Figure 4: In anticipation of a recession, banks have increased their loan loss provisions

Earnings and margins are likely to deteriorate further

With the weakening economic outlook and the impact of tighter monetary policy starting to be felt in the real economy, we expect to see a deterioration in corporate earnings and margins. So far, roughly 100 companies have issued earnings guidance for 1Q23, nearly 80% of which are negative. At the sector level, the information technology sector has the highest number of companies issuing negative guidances, reflecting the headwinds faced by big tech firms. 

Many companies have cited poorer macroeconomic conditions, as well as higher cost pressures coming from raw materials and wages, as reasons for the bleaker outlook. Overleveraged corporates will also feel the heat from increased borrowing costs, again affecting their profitability. 

(Related Article: Higher-for-longer interest rates to slow economic growth and drive the US economy into a recession)

Based on the latest numbers, the median consensus forecast is for the S&P 500 Index to see an earnings decline of -1.4% in 2023. This is relatively mild compared to previous recession years, where earnings fell between -10% and -20%. As it stands, corporate earnings are still slightly more optimistic than they should be and are not an accurate reflection of recessionary conditions. Even though earnings estimates have been reduced by roughly -8% since the start of 2022, it is important to remember that they are coming off a very high base.

With global growth decelerating and a recession looming, we expect further cuts moving forward, putting a lid on equity prices. Even though margins have started to compress in the recent months, they are still above their five-year average and well above levels that are consistent with a recession, even a mild one (Figure 5). What is more astounding is that operating margins are expected to hit 16% in 2023, the highest in over 20 years – an unlikely scenario in our opinion. Similar to earnings, we expect margins to deteriorate as well.

Figure 5: Operating margins are well above their long-term average 

Maintain 2.5 Stars “Neutral” as earnings headwinds mount

Looking ahead, we will maintain our rating of 2.5 Stars “Neutral” for US equities given the worsening macroeconomic data and mounting earnings headwinds. Even though share prices have corrected by approximately -15% since their peak since early last year, valuations are far from cheap relative to historical standards. Based on our estimates, US equities are currently trading at close to 16.7X 2024E EPS, which represents a paltry upside potential of 7.6% (Table 1). 

Table 1: Earnings growth of US equities to remain challenged ahead

On a relative basis, US equities are also looking a lot less attractive compared to fixed income. Following the sharp rise in interest rates, bond yields have surged, resulting in tighter spreads between earnings yield and bond yields. As of 7 March 2023, the spread between the two has reached 0.57%, one of the lowest points over the past 10 years (Figure 6). 

As such, the risk-reward ratio for investing in equities remains very unfavourable. In terms of asset allocation, our preference is for fixed income over equities. Within the fixed income space, we prefer investment grade bonds over high yield bonds as we believe a more defensive positioning is desirable in a recessionary environment. 

Figure 6: US equities are a lot less attractive relative to fixed income

In terms of duration, we like short duration bonds compared to longer term bonds. Yields on short duration bonds have moved significantly higher as compared to longer term bonds, implying that investors can receive higher returns without having to take on greater duration risk. The Nikko AM Shenton Short Term Bond Fund, United SGD Fund, and the LionGlobal Short Duration Bond Fund are three funds worth considering. 

With regards to equities, we recommend investors to adopt a quality/value tilt. Stocks with quality/value characteristics have proven to be more resilient compared to growth stocks in a recessionary environment as they tend to experience smaller EPS declines and maximum drawdowns during times of market turmoil. The rotation back into quality/value stocks has only just begun, and we expect these stocks to continue outperforming growth in an environment of persistent inflation and higher interest rates. 

Investors who are keen to add exposure to US quality/value companies can do so via the JPMorgan US Quality Factor ETF (NYSE:JQUA) and the JPMorgan Funds - US Value A (acc) SGD.

(Related Article: Quality investing: The answer to outperforming growth in a recession (and even in the long term)

(Related Article: Rise of the underdog. The comeback of US Value stocks)

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.