You wouldn’t necessarily know it from “Greedflation” banter and the perception that corporations are engaged in “profiteering” in the wake of overlapping crises, but corporate America is experiencing an earnings recession.
Scoff as you will, but every discussion can’t be wide-ranging and nuanced. Sometimes, we have to focus on a set of commonly used definitions and measures, even when we know they don’t tell “the whole story” or are otherwise imperfect. If not, it becomes quite difficult to talk about anything.
Earnings season in the US kicks off next week, and consensus sees a 7% YoY decline for aggregate index EPS. If realized, that’ll be the biggest drop since Q3 2020.
Notwithstanding any “low bar”-clearing, profits will almost surely decline, which’ll make two quarters in a row. Currently, consensus expects another YoY drop in Q2.
The issue is margin compression. Here again, I’m asking readers to focus on the numbers you’re going to see and read about, not on any alternative measures which may or may not tell a different story.
There are a number of government data series which offer a more comprehensive look at profitability for firms across the world’s largest economy. Some of the same datasets can be leveraged to refine the profit narrative. SocGen’s Albert Edwards this week suggested that, as of Q4, US corporations were still indulging in egregious profiteering at the possible expense of societal cohesion.
I’d agree with Edwards on that latter point, but for our purposes here, note that reported margins for the aggregate S&P 500 are seen contracting by almost 150bps in Q1 versus the same period last year. If realized, that’d count as one of the more severe examples of YoY margin compression in more than three decades.
Of course, this is the snapback from the pandemic margin expansion, which surprised many market observers (not to mention corporate executives). Pricing power during the post-pandemic inflation was robust. Costs rose too, but on a lag, which translated into record profitability.
Now comes the hangover. Just three sectors are expected to have expanded margins last quarter. Only energy is seen reporting a meaningful improvement in profitability.
As Goldman pointed out this week, info tech, comms services and health care are all likely to report margin declines in the neighborhood of 300bps. Together, those sectors comprise nearly 40% of aggregate index sales. Their share of index profits is even larger. “Results will vary markedly even within sectors,” the bank’s Lily Calcagnini wrote, using tech as an example.
Broadly, info tech EPS is seen falling 16% YoY, but drilling down, software & services may manage to grow earnings, while semiconductor stocks are poised to report a 42% decline in EPS “thanks” to more than 1,000bps of margin compression.
The bottom line (pun fully intended) is that we are, in fact, witnessing the phenomenon that top-down strategists have warned about for nearly a year now. Sales are still growing, but at an anemic rate (as pricing power wanes), but margins are contracting fairly dramatically for a variety of reasons.
Panning quickly back out, the bigger question going forward is whether the expected rebound in profit growth after one more quarter of contraction proves too optimistic.
In that regard, I’d just state the obvious: Consensus expects EPS growth to turn positive again during the same two quarters that many economists suspect could mark the onset of recession.
I’m a little surprised at the significant downturn in semiconductor earnings. Not a lot surprised because I am well aware that the crypto mining craze mixed with work from home definitely exploded demand. At this point, you can find extremely discounted computer equipment and components with ease. The reason I’m surprised is because of the CHIPS act, which I reasoned would increase demand through the on-shoring of semiconductor production that has been reliant on foreign providers. Wouldn’t the influx of government funding offset the reduction in demand for consumer products?
I feel we are still far from seeing any of that flow through to actual earnings – as with any CapEx, there is going to be a lag in ROI and in this case it will be a longer lag simply because firms need to build things from the bottom up. But that is my only narrowly educated guess.
CHIPs will not change which companies make semiconductors, just shift some of the manufacturing to US-sited fabs and assembly-test facilities. It will not accelerate semiconductor demand growth or reduce the cyclicality of the industry. Since those new fabs won’t come online for a year or more, the increase in semicap equipment revenue is still a ways off. Right now, CHIPs is mostly driving E&C (engineering and construction) revenue.
Good point, JL. We’re all getting excited about “the $50 billion” Chips Act. One hurdle is the restriction on any recipient of the aid doing business in China which will be difficult for some domestic and foreign companies.
But it is even more interesting to look at the actual numbers. That $50 billion sum sounds good, but only $23 billion of it is earmarked to support onshore fab construction. It’s still a lot, but it will be spent over ten (10) years, not all at once. Given the $20+ billion cost of building an advanced fab from the ground up, $2.3 billion per year appears to be woefully insufficient.
Part of the lack of benefit from the CHIPS act so far is that it will take 2-3 years at least to add whatever capacity is seen as economically viable. Suppliers must keep up with foundries as well. There will be a big lag here. Most of the output so far is a brief burst of political points.
Good table from GS.
Interesting to think about how it may look different by 3Q23. For example, bank EPS YOY is unlikely to be +11% in 3Q; I’m thinking a meaningfully negative percentage. Semi EPS YOY is likely to still be a negative percentage, but a little less so.
Also interesting to look at change in consensus 2023 earnings over the past 3 months. I pulled consensus net income for all S&P500 constituents as of now / 1 mo ago / 3 mo ago, summed for total S&P500 and by sector, and calculated the percentage change in the summed net income from 1 mo and 3 mo ago to now. This is a crude calculation, of course.
Category L1M%chg L3M%chg
S&P500 -0.6% -3.8%.
Bus Srvc +0.2% +1.0%
Cons Cyclical +0.1% -7.4%
Cons Non-Cycl +0.1% -2.4%
Cons Srvc -0.4% -0.8%
Energy -3.1% -9.2%
Finance -1.5% -3.0%
Healthcare -0.3% -4.2%
Industrials +0.3% -2.0%
Materials +0.9% -7.2%
Technology -0.3% -2.6%
Telecom -0.3% -4.8%
Utilities -0.1% -1.0%