Predictions About The Future

With earnings season just days away in the US, it’s not necessarily this quarter’s results investors should fear, but rather guidance, formal or otherwise.

Concerns around a potential wave of downgrades and revisions are pervasive, and while I personally think market participants are underestimating the potential for big misses in the here and now, the bar for Q2 results is actually pretty low. Consensus expects just 6% YoY growth, and just 2% excluding energy and financials. Margins are seen contracting by 18bps.

That sounds eminently achievable, with a few caveats. The fraught macro backdrop likely had an adverse impact on a wide range of companies. Given years of low macro volatility and recency bias, company analysts and investors may be surprised at the extent to which macro factors can impact virtually every facet of a business when the operating environment is cumbersome and the crosscurrents unforgiving.

Given rampant uncertainty, it’s very difficult to assign probabilities to critical variables in the profit equation, including and especially input costs and risk-free rates. That’s reflected, ironically, in market-based probabilities (figure above).

Relatedly, the currency headwind (i.e., a stronger dollar) was likely a drag for some companies last quarter, and many firms probably felt what certainly looked like a rapid loss of economic momentum in June.

Still, Q2 results may clear a low bar. After that, it’s anyone’s guess. “In our baseline outlook, which assumes the economy avoids recession, our EPS estimates are below consensus for H2 2022 and 2023,” Goldman reiterated, in a note out Friday evening. The bank sees 8% EPS growth for S&P companies this year ($226 in aggregate earnings) and 6% growth in 2023 (to $239). Some readers might be inclined to call those figures optimistic, but they’re materially lower than consensus bottom-up (figure below).

As discussed at some length here, Goldman thinks margin estimates are “overly optimistic.” “Q2 earnings season will likely be a catalyst for negative revisions as companies offer cautious commentary,” the bank’s David Kostin said.

Although top-down strategists are decidedly more cautious now than they were just a few months ago, the Street seems content to stick with a non-recession scenario until a recession actually materializes. Goldman still sees the S&P at 4,300 by year-end as the US economy averts a downturn.

Should a “moderate” recession come calling, Kostin sees the S&P at 3,150, driven in part by additional multiple contraction. Although aggregate 2023 earnings would likely be around $200 in the event of a downturn, bottom-up consensus would probably only get halfway there over the next six months. Applying a 14x multiple to $225 gets you the 3,150.

The tables (below) are useful, particularly the figure on the right, which shows the sector breakdown both for forward EPS growth in Goldman’s recession scenario and a look at how each sector fared during median recessions dating back four decades.

It’s easy to get the impression (and not just from Goldman), that big-picture, macro-focused equity strategists are keen to be on the record with fairly detailed scenario analyses for a potential US downturn, while retaining non-recessionary S&P targets until their colleagues in econ adopt a recession as the official house call.

Kostin described two risks which could prompt earnings to fall more than usual in a recession. “If inflation concerns were to limit the degree of monetary or fiscal policy support, a recession could lead to even larger economic and earnings growth declines than we model,” he wrote, adding that “the worst earnings recessions have historically reflected concentrated sector weakness rather than deep economic contractions.” He cited 1990, 2001 and 2008, when earnings declines were amplified by pain in Autos, Info Tech and Financials, respectively.

Policy optionality is indeed limited by inflation. And also by politics. The two aren’t separate either. Inflation will be the key talking point for Republicans seeking to retake Congress in November. The GOP will claim inflation is Democrats’ fault, but even if they (the GOP) had a plan for reining it in (which they don’t), they won’t be able to secure a large enough majority to get anything done, especially considering they won’t have the White House.

As for the risk associated with an outsized decline in earnings in a key sector with the potential to weigh heavily on aggregate corporate profits, Goldman wrote that “these sector dynamics are difficult to model.” Kostin said that currently, the bank doesn’t “see any sector that appears obviously vulnerable.” Still, he did caution that “Tech stands out as a sector with high margins relative to history and a large weight in the S&P 500.”

Predictions are tough. Especially right now. And particularly about the future.