Q3 Earnings Strength May Prove Fleeting

For some time now, Morgan Stanley’s Global Investment Committee has been expecting the Federal Reserve’s accelerated policy tightening to slow the U.S. economy and reveal the vulnerability of corporate earnings.

Specifically, we have been thinking that the third-quarter earnings season would bring a decline of around 10% in corporate earnings forecasts and a reset of 2023 expectations—moves that would help establish a bottom for this painful bear market.

But our optimism may have been premature.

Instead of a recalibration, earnings resilience seems to be the driving narrative these days. With about 20% of S&P 500 companies having reported to date, a FactSet analysis combining actual and estimated results pegs the year-over-year sales growth for the index constituents at 8.5% and earnings growth at 1.5%. These results are being heralded as upside surprises against recently reduced expectations for the quarter.

Meanwhile, Wall Street analysts’ estimates for corporate earnings for the year ahead have only dropped by 2% from January 2022 predictions. This stands in contrast to the average of the last 25 years, in which estimates have dropped by about 6% from January through year-end, according to independent researchers at Evercore ISI. 

Our concern is that the current perceived earnings strength may be temporary and the outlook overly optimistic. And importantly, the longer it takes for earnings estimates to adjust, the longer the current equity bear market is likely to persist.

A key question for investors considering recent earnings results and the future outlook is whether or not Fed policy has already slowed consumer demand and inflation has peaked.

Recent data including the Atlanta Fed’s GDPNow figures suggest it hasn’t, instead painting a picture of a strong consumer and room for companies to keep prices higher. For example, while weakness is apparent in goods manufacturing, consumer spending seems to be holding up well in services, and GDP forecasts have edged higher in recent weeks. Also, many companies are still talking about being able to raise prices to bolster revenues, underscoring the persistence of inflation and undercutting the idea that the Fed has made significant progress in taming it.

However, we believe this interpretation of the data offers a confusing message about the outlook for companies’ future profitability. The current level of inflation cannot continue indefinitely, given the central bank’s resolve around lowering inflation and what we see as a temporary extreme in consumption patterns that has helped drive prices higher but will eventually normalize. 

Another factor that strikes us as misleading is the disconnect between company guidance on future earnings and recent showings of CEO confidence, as measured by The Conference Board. The recently released fourth-quarter survey results show that CEO confidence has sunk to its lowest levels since the Great Recession. Views on current conditions and expectations for the future both deteriorated, with 98% of respondents saying they are preparing for a U.S. recession. And yet, scans of earnings calls transcripts suggest few explicit shifts in guidance from the C-suite.

One area where investor anxiety is starting to surface is in currencies, where the 17% appreciation of the U.S. dollar so far in 2022 is not only denting the value of sales made abroad when translated back to dollars, but also curbing actual demand levels in key markets such as the U.K., Europe and Japan. Even so, few company executives have been willing to focus on the vulnerabilities that tend to follow currency surges, such as deteriorating international sales outlooks and worsening competitive positioning for multinationals. 

All told, 2023 earnings estimates have barely budged, and investors’ positive outlooks are still not reflecting the likely ultimate reset. Meanwhile, our conviction that a profits recession is coming has only strengthened in the last few weeks. We fear that this grinding rollercoaster ride in equity markets may simply take longer to reach a buyable bottom. 

Investors should consider avoiding the temptation to chase bear-market rallies premised solely on macro factors. Remember that earnings achievability matters and focus on sustainable fundamentals. We see opportunities for stock selection in healthcare, financials, energy, industrials and defense.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from October 24, 2022, “Third Quarter Earnings Send Mixed Messages.” Ask your Morgan Stanley Financial Advisor for a copy.