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SUMMARY
- US earnings estimates appear to us to have bottomed…
- …as corporate efficiencies and pricing power provide support.
- We remain cautiously optimistic on stocks.
This week we are interrupting your regular scheduled programming - the reality TV show that is the US debt ceiling debate – to talk corporate earnings trends. With a debt ceiling deal agreed to in principle over the weekend by White House negotiators, investors’ focus will likely shift to earnings fundamentals…and the news here is improving, in our view. Earnings are less salacious, but in our view are more impactful to stock prices in the longer run.
Q1 Results: Better than Expected, Led by Tech, Cyclical and Consumer Companies
With most of the S&P 500 having now reported first quarter results, we can say with confidence that it was a successful earnings season. Looking through the lens of earnings ‘estimates’ gives us hope that we’ve seen the bottom in earnings for this cycle.
Earnings estimates are published by Wall Street analysts for every company in the S&P 500. Analysts derive these estimates by monitoring industry trends, reviewing data, guidance furnished by company management, and through conversations with employees, suppliers, and customers. According to data from Ned David Research (NDR), close to 80% of all S&P 500 companies beat the consensus analyst earnings estimate this quarter, a stronger result than in Q4 or Q3 of 2022. The Technology sector was the standout, in our view, with almost 90% of tech companies beating estimates, by a median rate of roughly 8%. Other sectors such as energy, industrials, materials and consumer cyclicals also had a beat rate above 80%.
Importantly, this widespread earnings strength seen in Q1 is now starting to pull up 12-month forward earnings estimates for the S&P 500 in general, reversing an almost year-long decline in forward earnings estimates (see chart, below).
Why Earnings are Improving - Pricing Power Still Alive and Well
In our 2023 Outlook, we hypothesized that S&P 500 earnings this year would prove more resilient than many feared. This view was based on our belief that in a higher inflation environment, ‘nominal’ economic growth (including inflation) was likely to remain positive and supportive of revenue growth. In addition, we anticipated US corporate managers, skilled at managing costs in uncertain environments, would surprise investors with their effective cost-cutting. We believed the relatively robust employment backdrop could keep consumers spending and provide companies ‘pricing power’, the ability to pass on higher prices to end-users.
In this just completed Q1 earnings season, we believe we are seeing this thesis start to play out in the United States. A rough proxy for corporate pricing power can be seen by studying the relationship between inflation rates in consumer prices (as illustrated by the Consumer Price Index, or ‘CPI’) and inflation rates in input prices for companies (represented by the Producer Price Index, or ‘PPI’). Note that, for the first time in roughly 2 years, CPI is higher than PPI…suggesting to us that companies are successfully raising prices on consumers (see chart, above) and protecting profit margins. This differential between CPI and PPI is at its highest point in the last decade, suggesting to us that CPI will remain above PPI for some time.
Conclusion: Stocks’ Earnings Fundamentals and Technical Picture Improving
With progress being made over the weekend on the debt ceiling negotiations – President Biden and Speaker of the House McCarthy agreed in principle to a deal - we think investors will start to prioritize company fundamentals over political turmoil. US earnings fundamentals are showing their first signs of stabilizing in roughly a year, a good sign for stocks, in our view. Late last week, the S&P 500 broke above what we view as significant technical resistance around 4200. A lasting breach above would be an incremental positive sign to us that 2023’s market rally has staying power. We remain cautiously optimistic on US stocks.
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