Q1 Earnings Preview: More Pain Seen For Bottom Lines As Inflation, High Rates Raise Pressure

Financial industry turmoil and debate over the Fed’s rate path set the stage for a Q1 earnings season that might raise more questions about corporate health than it answers.

Major banks and airlines open the season in mid-April after a disappointing Q4 that saw S&P 500 earnings per share (EPS) fall nearly 4%. The slump is widely expected to worsen in Q1, falling more than 6% year over year, according to research firm FactSet.

The definition of an “earnings recession” is when earnings decline two quarters in a row. If analysts are right, we’re about to be in one.

What’s the problem? A bunch of things, including the strong dollar, slowing consumer and business demand, tough comparisons versus year-ago earnings, and rising interest rates as the Federal Reserve again tightened the screws at its March meeting. All these factors can slow earnings growth, with some sectors pressured more than others.

One thing you probably can’t blame for Q1’s troubles—though it’s likely to have an impact later this year—is the recent banking turmoil. More on that below.

More pain seen ahead

Before touching on Q1 earnings expectations by sector, let’s review a few reasons why many analysts remain bearish on the earnings outlook for Q1 and beyond: 

• Recent downward momentum in revisions by companies. Through late March, 79 S&P 500 companies had issued negative earnings per share guidance for Q1 versus just 27 that issued positive guidance, according to FactSet.
• The lagging impact of tighter monetary policy is still working through the economy and input costs remain high for many segments of the market, says Liz Ann Sonders, chief investment strategist at Schwab. Decelerating growth continues to weigh on productivity.
• The Leading Economic Index (LEI) from The Conference Board fell again in February and is down month over month for 11 consecutive months (a streak only seen during recessions).
• The ISM Manufacturing Index’s new orders component remains in contraction where it’s been for six consecutive months.
• Rapid disinflation on the goods side of the economy is sending a worrisome signal for revenue and profits, especially given S&P revenue growth in 2022 was mostly due to high inflation (unit growth was mediocre), Sonders notes.

Beyond that, recent layoffs across the info tech sector, including Amazon’s (AMZN) late-March announcement that it would lay off workers in its cloud business, has driven negative sentiment heading into earnings. The mega-cap tech companies, including AMZN, Microsoft (MSFT), and Apple (AAPL) all disappointed with their earnings last time out, and more negative news from any or all of them might taint this earnings season, too.

That said, it’s likely that big banks will set the tone as they kick off the earnings season the middle of next month as they’re center stage in the recent financial turmoil. 

Big Q1 declines seen for materials, real estate, health care

Eight of 11 S&P 500 sectors are expected to see earnings fall year over year in Q1, according to research firm CFRA, with the worst losses coming from materials, real estate, health care, and communication services. However, consumer discretionary, industrials, and energy all could see better than 13% year-over-year EPS gains in Q1, CFRA forecasts.

The closely watched financials sector is expected see EPS fall nearly 8% in Q1 and fall more than 2% for calendar year 2023, CFRA says.

Analysts expect a 6.6% earnings decline across all sectors in Q1, according to FactSet’s latest data released March 31. That reflects declining hopes since the start of the year, when the average Q1 estimate was for just a slight decrease, according to FactSet. The trend for nearly a year now has been falling analyst estimates over the course of the quarter as companies guide lower. 

Materials, consumer discretionary and industrials are the three sectors where earnings estimates have fallen most since the start of the year, FactSet noted. Familiar companies that have seen estimates fall substantially include Amazon, Tesla (TSLA), United Airlines (UAL), and Boeing (BA).

While CFRA still sees overall 2023 S&P 500 earnings per share (EPS) falling just slightly from last year’s $219.25, some analysts are far more bearish, projecting EPS of $200 or less.

Banking turmoil’s impact

The elephant in the room is credit, both for consumers and businesses, and it could tighten if banks and their balance sheets come under more scrutiny. Banks may become more reluctant to lend to certain businesses, which could dry up venture capital, commercial real estate, and other businesses dependent on a relatively free flow of funds.

Ultimately, this would likely lead to slower economic growth and almost certainly to less direct business for banks. Keep an eye on credit spreads to get a sense of whether business activity is slowing, which would likely factor into falling earnings expectations as the year advances.

There’ve also already been more calls for bank regulation in the wake of this instability. Tighter regulation, if it comes, often means narrowing opportunity for banks to grow their businesses.

Earnings, even more than the Fed, play directly into stock valuations. Heading into earnings season, the SPX had a 12-month forward Price-Earnings (P/E) ratio near 18, close to the 10-year average, according to FactSet. That sounds relatively benign, and certainly could be if the “E” part of the equation remains stable. Analysts expect earnings to rebound smartly later in 2023, thanks in part to hopes for an improving economy and easier comparison to the previous year in coming quarters.

With Q1 earnings not even started, it’s a bit early to start worrying about the full year. But if analysts start rolling back their earnings estimates for later this year, P/E could start looking higher than normal unless the SPX declines. That’s why company guidance in coming weeks for Q2 and beyond is so important and will likely invite as much or more scrutiny as Q1 performance numbers roll in. Analysts have their pencils and scorecards ready, so to speak, and could mark them with red ink if they don’t like what they hear from some of the major companies. 

If the red ink flows toward full-year earnings expectations, it’ll be tough sledding for market bulls hoping for a 2023 Fed “pause” rally or a possible rate cut by later this year. The Fed can perhaps take its foot off the brake a bit, though inflation remains near 5%, making that a tough call.  But if companies can’t find a way to improve margins and boost profits, any stock market rally based on rates could be called into question. In late March, for instance, Nike (NKE) shares slipped despite strong earnings, hurt by worries over the company’s slumping gross margin amid inventory issues. Margins come into sharp focus during earnings season, and more companies could see their stocks punished if they can’t promise better profits ahead. Unfortunately, inflation remains a problem, giving companies the unappetizing choice of raising prices or eating the higher wholesale costs (and hurting their margins). 

In late March, for instance, Nike (NKE) shares slipped despite strong earnings, hurt by worries over the company’s slumping gross margin amid inventory issues. Margins come into sharp focus during earnings season, and more companies could see their stocks punished if they can’t promise better profits ahead. Unfortunately, inflation remains a problem, giving companies the unappetizing choice of raising prices or eating the higher wholesale costs (and hurting their margins).

Bright Spot?

Though earnings season is still over a week away, a smattering of company reports in the final week of March inspired some optimism in a market that’s grown used to expecting poor quarterly results. When you look over the companies that reported recently, including Walgreen’s Boots Alliance (WBA), lululemon (LULU), Micron (MU), Carnival (CCL), McCormick (MCK), and Paychex (PAYX), there was a lot to like even if not all of them sounded incredibly optimistic about the rest of the year.

By and large, these firms either beat Wall Street’s expectations or gave investors reasons to hope the worst of their earnings struggles may be behind.

Another positive feature in the recent flurry of company reports was the top line, which is a lot harder for corporate finance whizzes to dress up. The bottom line is typically where you can find ways to “window dress” a quarter and make it look a bit healthier than it may have actually been. Revenue, on the other hand, is going to either be good or bad, and kind of speaks for itself. Approximately 75% of S&P companies that reported in March’s final week beat analysts’ revenue expectations. That’s an area to watch as earnings season begins.

TD Ameritrade® commentary for educational purposes only. Member SIPC.

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