S&P 500 earnings growth rate: less than 3%

Leora Heathcote

Hot

8 mins

Oct 09, 2022 12:19

The earnings of the S&P 500 are expected to grow at a rate of less than 3% year-over-year. If this growth rate is realized, it would represent a decline in earnings when adjusted for inflation. This week's CPI reading, combined with the resilient [...]

The third-quarter earnings season is crucial for the overall market and individual companies, as the economy struggles with elevated inflation, aggressive Federal Reserve rate hikes, and rising risks of a recession in 2023. Expectations are low going into this reporting season, with earnings slated to grow at less than 3% year-over-year, due to factors such as slowing economic growth, rising labor and input costs, Ukraine, China’s zero-Covid policy, supply chain, and a strong dollar. Additionally, Hurricane Ian could have caused some disruptions at quarter end and will undoubtedly begin to show up as losses for some insurance companies. As is typical, the actual performance should exceed earnings estimates, but forward guidance will be crucial with the significant worries about the deteriorating economic outlook and cost pressures. The ability of companies to pass on higher prices to protect profit margins will remain a critical variable.

The focus this week will be on the financials, specifically the banks, as 15 S&P 500 companies are scheduled to report earnings. Among the banks reporting are JPMorgan Chase, Morgan Stanley, PNC, U.S. Bancorp, Citigroup, and Wells Fargo, so the results will provide financial results and a good idea of the operating environment. According to FactSet, the financials should be near the bottom of earnings growth rates, with consensus year-over-year earnings estimates showing a decline of -12% at quarter-end.

The banking sector has been under pressure this year due to concerns about future economic growth. However, banks stocks outperformed in the third quarter thanks to a sharp rise in interest rates. The positives from the earnings reports included better net interest income, net interest margins (NIM), and loan growth. NIM is the amount a bank earns in interest on loans compared to the amount it pays in interest on deposits, which was helped by the rise in rates. On the downside, banks were likely to increase loan loss reserves to prepare for growing future credit losses that would accompany a possible recession. These reserves should be for future loan losses because credit trends were expected to remain healthy. However, the growing loan loss provisions made the earnings declines worse than they would otherwise be. Other negatives included lower investment banking revenues, a reduction in mortgage banking, higher costs, and weaker wealth management fees due to the market decline. In summary, the core banking and lending businesses appeared to be healthier than the headline earnings suggested.

The energy sector is poised for big growth in the coming years, thanks to rising energy prices. Companies in the sector are expected to see their earnings increase by over 100% year-over-year, while sales growth comes in at over 30%. Some investors remain positive on the sector, as regulatory filings showed that Berkshire Hathaway continued to buy shares of Occidental Petroleum in the last week of September. Buffett's Berkshire now owns about 21% of Occidental Petroleum.

The sales growth for the quarter may appear elevated, but it will be flattered by the high inflation rate. Sales growth is closely tied to nominal GDP growth, which combines the after-inflation economic growth (real GDP) with inflation. With nominal GDP growth expected to be around 7.5% year-over-year for the third quarter, the consensus estimate of 8.7% year-over-year sales growth for the S&P 500 looks achievable.

This simple model indicates that profit margins are under pressure due to higher prices for producers' inputs. As a result, sales growth for the S&P 500 is only expected to result in low single-digit earnings growth.

I expect oil prices to continue to rise in the fourth quarter, but at a slower pace than in the third quarter. Energy costs will remain a headwind for many companies, but labor costs are also likely to increase.

It is clear that transportation and freight prices are still under pressure, with fuel and wage costs continuing to be a major factor. However, it is encouraging to see that overseas shipping costs have come down from their peak levels. This shows that the market is slowly starting to correct itself and that prices may eventually return to more reasonable levels.

The pandemic has caused a change in consumer needs, with a greater demand for goods relative to services. This has led to some retailers having excess inventory, which is now being discounted due to the easing demand. This is likely to put pressure on earnings within the consumer discretionary sector.

While this week's consumer inflation reading is not likely to relieve worries about cost increases, it is still lower than June's reading. CPI is expected to rise to 8.0% year-over-year, which is below June's 9.1% level. However, the level of persistent inflation will likely remain uncomfortably high. Prices rising faster than wages is a recipe for declining after-inflation demand, which adds to pressure on growth. A high inflation print combined with the continued robust labor market evidenced by the 3.5% unemployment rate reported last week should make a 75 basis point (0.75%) hike from the Federal Reserve in November a virtual certainty.

The strong US dollar is likely to continue to negatively impact the earnings of companies doing business overseas. With around 40% of the sales of S&P 500 companies coming from outside the US, this is likely to be a constant issue for businesses.

The Federal Reserve's aggressive rate hikes are expected to weigh on the economic outlook, and continued cost pressures could lead to slower growth in earnings. Actual earnings may exceed estimates, but forward guidance will be even more important in the current environment.