Q3 was a tale of two halves. We started the quarter riding the high of the rally that began at the end of Q2, after narrowly averting a debt ceiling crisis. Economic data remained resilient while the disinflationary process that began last year continued to move in the right direction. The light at the end of the tightening cycle was seemingly drawing closer. All at once traders and economists alike seemed to come to the conclusion that the elusive recession, many had been calling for, was not coming - declaring the Federal Reserve had indeed pulled off “immaculate disinflation”. The conclusion - a soft landing or even a no landing scenario was now likely.
As is usually the case that capitulation came at exactly the wrong time. In some ways the catalyst that kicked off the selloff, that would carry through the end of the quarter, came from an unlikely source. However, in all actuality it has been the same issue hanging over markets over the last two years - rising rates.
The headline that provided that spark was the surprise announcement by the BOJ that it would widen the trading bands for its government bonds signaling a further step toward normalizing its uber-accommodative policy stance. This was the spark, but it was a culmination of events including an imbalance in supply and demand created by the Fed’s ongoing QT program, increased Treasury issuance, less overseas demand, a credit downgrade highlighting growing deficits and the Fed’s higher for longer message that ultimately sent long-dated Treasury yields up ~75bps over the next two months.
In the final two months of the quarter the S&P 500 had pulled back about 7% from its high ending the Q3 down 3.6%. The improvement of market breadth that was so widely discussed during the rally also completely unwound with the equal-weight version of the index and the Russell 2k both clinging to YTD gains underperforming the benchmark S&P 500 by >11%.
As we enter Q3 earnings season the concerns continue to mount including an escalation of geopolitical tensions following the horrific events of this past weekend. Amidst the uncertainty equity markets are trying to find their footing with the hope that corporate earnings will once again prove to be more resilient than most had expected coming into the year.
Data compliments of FactSet Earnings Insight as of October 6
The Q2 earnings season began near the tail end of the rally we just described above. As we previewed, earnings estimates had been cut significantly in the twelve months leading into the quarter, making it easier for companies to clear the lowered bar. However, we were concerned given the shift in positioning dynamics that it would be difficult for stocks to rally on that news. That was largely how things played out.
During the quarter ~80% of companies beat estimates by nearly 8%. However, the stock reactions were reasonably muted. This was most apparent in some of the leadership pockets of the market. There were many instances where a company beat earnings along with an increase in guidance yet the stocks were unable to hold opening gaps.
Revenues continued to decelerate increasing only 1% YoY. This deceleration was somewhat overstated as revenue within the energy sector fell >25% due to the decline in oil prices, which accounted for a ~3% drag on the overall S&P 500 numbers (this will be a drag again this quarter). However, there were signs that the price increases put in place over the last year were starting to impact overall volumes.
As has been the case throughout the year management commentary remained cautious and that caution continued to be reflected in the fact that guidance was not moving higher despite the earnings beats. However, the cycle of earnings estimate cuts, which has also been ongoing for the last year, came to an end. Since mid-July 2023 estimates have ticked up ~2% while 2024 estimates have also inched up slightly.
Cost cutting, improving supply chains and lower commodity/logistics costs all helped the bottom line. Net margins improved to 11.7% from 11.5% in the previous quarter breaking a string of declines. On the flip side, wage pressures continued to be a concern and there were multiple companies noting an increase in interest rate expense.
Interestingly there doesn’t seem to be all that much buzz ahead of this quarter. Following three consecutive quarters of YoY declines, analysts are calling for earnings to be down 0.3%. However, given the typical beat rates I’d expect to break that streak. The negative revisions have stopped and following a solid quarter of economic data there isn’t much for the earnings bears to latch onto this time around, at least for this quarter, but there are some headwinds brewing.
We can start with wages. The full impact of ongoing labor strikes have yet to be felt and it seems these are becoming more commonplace. There are signs that wage pressures more broadly have been easing but they are likely still outpacing price increases.
Logistics costs will likely remain contained but the impact of rising fuel costs will start to be a drag something that multiple airline companies have highlighted intra-quarter.
Recent survey data has also pointed to some potential margin pressure with respondents highlighting that input costs are outpacing prices received.
If the recent rise in the USD continues that could start to impact multinational earnings. Since July the currency has rallied ~6% and is threatening to break out of the range that has been in place since the end of last year. According to FactSet about 40% S&P 500 revenues come from outside the US. I’ve seen analyst estimates suggesting that an 8-10% increase in the currency could negatively impact S&P 500 earnings by ~2%.
Last quarter some companies started highlighting that interest rate expense was moving higher. There is not an impending wave of maturities but assuming rates continue to hold around current levels for some time this will be a drag.
The higher cost of capital has started to impact capital return programs. There was a big drop in buybacks driven largely by a decline in the financial sector with continued banking concerns and impending regulatory changes. As cash flow is used to fund other capital expenditures like reshoring and increasing AI capabilities we could see this trend continue. Share repurchases shrink the public float, hence they help increase EPS. This also potentially removes a big underlying bid within the marketplace. If there were an in increase in the new excise tax this could also negatively impact buybacks going forward.
Credit conditions are tightening. Banks haven’t pulled back significantly from lending yet, but access to credit is getting more difficult. Delinquency rates have been moving higher most notably on private label cards. The consumer has continued to spend but more cracks are beginning to show. Savings rates are being depleted and there are mixed opinions about the potential impact with the restart of student loan payments.
With that back drop I’d expect banks will likely continue to increase provisioning and reserve builds. Commercial real estate portfolios will also be a focal point. These two factors will have a bigger impact on the small/medium sized regional banks so we could get lulled into a false sense of complacency early in the reporting cycle on that front. A couple other areas of focus within the sector will be net interest margins and updates about capital market activity. One of the biggest concerns for investors is how large of an uptick we will see in unrealized losses on the balance sheet given the recent rise in rates.
Shifting to the positive side of the equation. The cost cutting measures that have been instituted over recent quarters should continue to pay dividends. It also seems that the worst of the inventory destocking is over. Commentary from management teams across multiple industries have suggested that inventory levels have now been sufficiently drawn down and there could be a shift to restocking in the not too distant future.
With all the clouds on the horizon estimates are calling for an earnings inflection higher from here. For the S&P 500 to hit current estimates of ~1% YoY growth - Q4 earnings will need to jump 8% YoY. From there estimates for next year are looking pretty rosy too. Looking out to 2024 analysts project earnings to be up ~12%. If the economy starts to slowdown hitting those numbers seems unlikely. However, if this feels like Déjà vu that’s because it is.
There was a similar set up coming into this year. At the end of Q3 2022, S&P 500 estimates for this year were ~$240. By the time we hit the new year that had moved down to $230 and we’re hoping to end the year closer to $220, yet the equity market has held up pretty well.
Two of the biggest surprises of this year have been the resilience of the economy and corporate earnings. Economic data throughout last quarter remained strong so I’d be surprised if we got a big negative surprise . As is usually the case the focus will be on commentary about the future and guidance. With all of the uncertainty investors will be listening closely for an early indication suggesting the landscape is changing. Or like I said last quarter - maybe they’ll just be surprised again that it hasn’t.