Earnings season: what to expect from Q1

The main event this week will be the start of Q1 earnings season. Big banks including JP Morgan, Citi and Wells Fargo will be watched closely as they update the market on their earnings for the first three months of the year, but, more importantly, how the recent stress in the financial system which culminated in the collapse of major banks, has impacted their future plans for lending and bank liquidity more generally. This earnings season is important for a few reasons: 1, the market now expects earnings growth to fall last quarter, which suggest that corporate earnings are already in recession, 2, however, expectations for both earnings and sales growth is low, can companies beat earnings? 2, how are companies coping with higher interest rates, rising inflation and the prospect of a recession later this year? 3, analysts are still expecting earnings to grow in 2023 overall, however, will companies’ future expectations cause analysts to change their view on full year earnings and should we expect a wave of downgrades or upgrades?

Looking at analyst expectations first, according to FactSet, Wall Street analysts expect companies on the S&P 500 to report their second consecutive decline in earnings. They are expected to decline 6.8% from Q1 2022, which is the steepest earnings decline since Q2 2020, at the peak of the pandemic. It is also worth noting, that during Q1, analysts also reduced their estimates for corporate earnings by a larger than normal margin. Analysts reduced earnings estimates by 6.3%, the average reduction in estimates for Q1 earnings over the last 5 years has been 2.8%. In fact, the decline in earnings for Q1 2023 was larger than the 5, 10, 15 and 20-year average. Can things really be that bad? The answer will obviously have to come from the companies themselves, however, even then it isn’t looking good. According to FactSet, 78 US companies have issued negative EPS guidance for Q1, with only 28 companies issuing positive EPS guidance. As you can see, only 106 companies have issued guidance for Q1, however, this number is above the 5-year average, suggesting that companies want to manage expectations ahead of this earnings season. Added to this, the number of companies issuing negative EPS guidance is above the 10-year average, so one can assume that this earnings season might not be too pretty.

Tech companies are issuing the most negative guidance, with 27 companies expecting to see weaker EPS growth in Q1. This is unsurprising, since the tech sector continues to go through a multi-quarter re-set, with earnings and sales trending lower. However, in Q1, it is companies in the semiconductor and semiconductor equipment industries that are issuing the most negative guidance. This comes at an interesting juncture for the tech sector, as its stock has had a good start to the year, so far, the S&P 500 has risen more than 6.5%, led higher by the mega cap tech stocks. Thus, the question at this stage is: does it make sense for tech stocks to continue to rise when their earnings expectations are lower? If earnings from the tech sector come in weaker than expected, could there be a reckoning for their share prices? If yes, and if the mega cap tech companies see their earnings come in weaker than expected, then this could have a big impact on the S&P 500 overall. Just 20 stocks have accounted for almost 90% of the gains in the S&P 500 so far this year, led by tech giants including Nvidea, Meta and Salesforce. Apple has also seen its valuation rise by 30% so far this year, which accounts for $600bn, to put this in perspective, the valuation for the other stocks in the index is up some $320bn so far this year! If we strip out gains for the mega cap stocks, and the S&P 500 is up 1.4% for Q1, rather than the near 7% increase recorded if the mega caps are included.

Finally, it is worth noting that falling earnings will make companies price to earnings ratios deteriorate, and if earnings are weaker then stocks could appear more expensive. Companies in the S&P 500 are already trading at 18 times their projected earnings over the next 12 months, which is above the 17.3 level, which is the 10-year average. If this ratio rises, then investors may ditch US stocks and look for cheaper valuations elsewhere, for example in Europe.

Overall, a lot is resting on this earnings season, not least whether it will be the final nail in the coffin for the early 2023 stock market rally. Thus, it’s worth watching what the banks have to say this week closely.