The first half of the year turned out to be better than expected, with Europe dodging recession, China emerging from a multi-year lockdown and a tight U.S. labor market providing a boost to activity.

In brief

• With 253 companies reporting (58.2% of market capitalization), our current estimate for 2Q23 S&P 500 operating earnings per share is $51.13.

• Earnings dispersion is rising, as evidenced by the sharp decline expected in the profits of energy and materials companies.

• There is tension evolving as rising interest costs will be difficult to pass along to the end consumer if demand fades.

• Investors should continue to embrace a defensive posture and focus on low-beta, dividend-paying stocks. Growth stock exposure should be added on any weakness.

A better start than expected

Coming into 2023, investor optimism was hard to find. Data in the U.S. was deteriorating, Europe was destined for recession and China was still locked down under a zero-COVID policy. However, the first half of the year turned out to be better than expected, with Europe dodging recession, China emerging from a multi-year lockdown, and a tight U.S. labor market providing a boost to activity. On top of this, the sharp fall in interest rates and injection of liquidity that corresponded to bank failures in March effectively reset the recession shot clock, pushing expectations for slower growth and potentially a recession into 2024.

Against this backdrop of better-than-expected data, profits have surprised to the upside. We came into the year with a view that S&P 500 operating earnings would be flat-to-down in 2023, with the outturn dependent on whether the economy entered recession. However, with the second quarter earnings season underway, we are currently forecasting profit growth in the mid-single digits for the calendar year, particularly as results thus far have been better than expected. With 253 companies reporting (58.2% of market capitalization), our current estimate for 2Q23 S&P 500 operating earnings per share is $51.13. If realized, this would represent year-over-year earnings growth of 9.1%, but a quarter-over-quarter decline of 2.7%. Thus far, an impressive 73% of companies have beaten earnings estimates while only 51% of companies have beaten revenue estimates as inflation has slowed. However, both earnings and revenue surprises have been positive, with earnings beating estimates by an average of nearly 5%. Meanwhile, and arguably most importantly, profit margins have only declined slightly, with our current estimate tracking 11.3% versus 11.6% in 1Q23.

% of companies beating revenue and EPS estimates

This combination of resilient growth, better than expected profits and enthusiasm around artificial intelligence has led to a strong rally in U.S. equities so far this year. While we see room for this to continue in the near term, particularly as the breadth of the rally continues to increase, it is important to note that more than 90% of the S&P 500’s YTD gains have been driven by multiple expansion, rather than an improving outlook for corporate profits. With sentiment increasingly in the driver’s seat and equity positioning across systematic strategies continuing to rise, the market feels vulnerable to data releases that fail to meet expectations.

The devil is in the details

At the sector level, financials have kicked off the earnings season. However, profits in the financial sector continue to tell different stories on a year/year and quarter/quarter basis. Relative to 2Q22, the sector is tracking a significant bump in operating EPS, primarily due to favorable comparisons. In contrast, the q/q growth estimate is pointing towards a contraction in profitability and provides a timelier snapshot of the sector’s health. On average, net interest income declined, as weak C&I loan growth and a pickup in deposit betas pressured margins. Looking ahead, most firms provided weaker outlooks for net interest income, as non-interest-bearing deposits rollover and are repriced. Investment banking and trading revenues were soft as well due to subdued levels of market and M&A activity. Additionally, credit quality continues to normalize, with delinquencies trending towards pre-pandemic levels and provisions for loan losses increasing once again.

Net interest income has declined, but net interest margins have remained steady

The industrial sector is tracking y/y earnings growth of 24.0%, with strong results among the airlines, industrial conglomerates and defense names supporting the sector’s growth. The airlines have reported another strong quarter of profits, as robust demand for premium fares and international travel has offset labor and logistic costs. The industrial conglomerates continue to benefit from scale and diversified business mixes, while aerospace and defense continue to find support from the boom in air travel and defense sales. The positive performance in the sector has been partially offset by weak results in transport, which has suffered from lower volumes and sticky costs.

In contrast to industrials, energy and materials are tracking y/y earnings declines of 53.6% and 25.7%, respectively. After surging in 2022, crude oil and natural gas prices fell, on average, 31.8% and 68.6%, respectively, during the quarter. Similarly, the pullback in crude and intermediate material prices, along with muted manufacturing activity, have seemingly weighed on profits in the materials sector.

The consumer sectors are in line for another strong quarter of earnings, as spending remained robust in the second quarter. However, with inflation being stickier than expected and the consumer’s accumulated savings likely almost depleted, the shift away from non-essential spending has supported results in staples. Within consumer discretionary, the shift in spending habits have hurt the apparel names the most, but the sector still looks set to see earnings grow due to solid results in travel and lodging, restaurants and autos.

The health care sector, as per current estimates, has had another tough quarter. While increased procedural volumes and positive drug development has boosted profits, the rolling over of COVID-19 revenues, bloated R&D spending and high labor costs continue to weigh on profitability.

Communication services and information technology are tracking mixed quarters for earnings. The former is set see earnings grow 14.2% y/y, as subscriber and gaming growth remain solid and advertising revenues look set to come in higher than expected. Information technology, on the other hand, is tracking a smaller y/y increase of 1.4%. Results have been weaker among the hardware names given PC shipment decreased 13.4% y/y in 2Q23. Software names, on the other hand, have seen earnings hold up due to lower operating leverage and resilient demand for software services. 

Tug of war: Pricing power vs. higher rates

Over the past year, inflation has provided support for both revenues and profits, while the full impact of higher rates, for the most part, has yet to be felt. However, there appears to be tension evolving between the two, as higher rates begin to impact business spending and decelerating inflation weighs on cash flows.

To start, many focus on the impact of higher interest rates on aggregate demand, but the impact of higher interest rates on aggregate supply is quite significant. On the demand side, higher rates discourage spending and lower aggregate demand, which in turn hurts profits. On the supply side, high-interest rates lead to elevated interest expenses for businesses and thereby weigh on profitability. According to research from Bernanke and Gertler, more than 40% of the hit to business income following Fed rate hikes is via higher interest expense. Furthermore, their research suggests that firms begin feeling the “cash squeeze” 6-9 months after monetary tightening ends, which usually corresponds with a deteriorating economic environment1. As we noted in our 1Q23 earnings bulletin, this trend is evident in S&P 500 profit growth, which has historically troughed once a recession is already well underway as revenues decrease but costs remain elevated. Importantly, interest expense tends to stay elevated even after monetary tightening ends, as businesses are forced to borrow at higher rates to both support cash flows and refinance maturing debt.

Interest expense coverage ratios continue to tick lower

Up until this point, however, higher costs have been offset by higher prices; there is no need to look further than the past two years for evidence of this. Corporate earnings have grown remarkably despite unprecedented levels of inflation and economic uncertainty, as robust fiscal and monetary stimulus, along with the economic reopening, buoyed aggregate demand. In turn, firms were able to pass along the cost of higher inflation to consumers.

However, as inflation moderates, what happens to pricing power? The answer is, it depends. According to research from the Federal Reserve Bank of New York2, the rate of consumer price inflation has little impact on the pricing decisions of firms; put differently, businesses rarely change prices because inflation is accelerating or decelerating. Instead, demand and input costs are the key determinants of prices.

On the cost front, firms are primarily concerned about their own individual operating cost basket rather than headline inflation. Empirically, we have seen this supported in management earnings calls as well, with many firms providing details on how “their specific cost basket” has changed. Yet, in other areas of business, such as services, where costs (specifically wages) are still near all-time highs, we continue to see businesses pass these higher costs along to the end consumer.

Pricing and sales expectations continue to deteriorate

Looking ahead, it seems reasonable to expect that elevated interest expense will weigh on margins, while rising wages and other input costs will continue to be passed along in the form of higher prices assuming demand does not falter. However, with excess savings near depletion, wage growth decelerating and labor markets showing signs of cooling, softer demand may well materialize in the months ahead. This will create a challenging profit environment as we move into late 2023/early 2024, leading firms to cut back on spending and potentially ushering an environment of cooler economic activity. 

Investment implications

With S&P 500 earnings per share estimates still near all-time highs, forward price-to-earnings ratios have left equity valuations at a premium, even when the ten largest names in the index are excluded. Against a backdrop where recession risks are rising, subdued volatility alongside these elevated valuations suggest that market sentiment may be too bullish, leaving the market vulnerable to a pullback. As such, investors should continue to embrace a defensive posture, and focus on low beta, dividend-paying stocks. We are inclined to take advantage of any pull-back in profitable growth and technology names should it materialize, but are not of the view that the current rally is one worth chasing.

1. Bernanke, Ben S. & Gertler, Mark. "Inside the Black Box: The Credit Channel of Monetary Policy Transmission." Journal of Economic Perspectives, 9 (4): 27-48. Fall 1995.

2. Dorga, Keshav & Heise, Sebastian. “Estimates of Cost-Price Passthrough from Business Survey Data.” Staff Report 1062, Federal Reserve Bank of New York. June 2023.

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