Q3 Earnings: Recession Might End For Corporations, But Stronger Results May Not Aid Market Much

A U.S. economic recession may or may not be in the cards going into 2023’s final quarter, but at least the “earnings recession” could be running out of steam.

The approaching third-quarter earnings season has a chance of being the first in a year to show rising profitability for S&P 500® companies. However, that won’t necessarily be enough to awaken stocks from their late-summer slumber. During the last three quarters, average S&P 500 earnings growth declined year over year, fitting the definition of an “earnings recession”—at least two quarters of year-over-year earnings declines—for the first time since the pandemic.

Strong consumer spending and easier year-over-year earnings comparisons for some key sectors could help the biggest 500 U.S. corporations get over the hump when earnings season begins in mid-October. Eight of the 11 S&P 500 sectors are expected to report year-over-year earnings growth in Q3, according to research firm FactSet, led by communication services and consumer discretionary firms.

Tough comparisons to the solid post-pandemic economy and rising interest rates clipped earnings growth for most S&P 500 sectors in late 2022 and the first half of 2023. Energy, which led earnings gainers in 2022 as crude oil prices rose following Russia’s invasion of Ukraine, helped bring overall earnings down earlier this year as crude prices fell. Crude has marched higher lately, however.

Analysts expect Q3 earnings to drop 0.1% from a year earlier before expected solid gains in Q4 and next year, FactSet said in its most recent Earnings Insight report last Friday. (The firm issues a new estimate each Friday ahead of and during earnings season, so this could change.) Analysts anticipate Q4 earnings growth of 8.3%, followed by 12.2% calendar-year growth in 2024. That compares with expected calendar-year growth of just 1.1% this year, FactSet said. Earnings fell 4.1% in Q2 of this year.

Anticipated improvement in bottom-line performance won’t necessarily light a fire under Wall Street, in part because stocks approach earnings at relatively high valuations compared with the historic average. Also, recent slower revenue growth has some analysts worried about company margins. Rising interest rates and inflation from soaring energy costs are other wild cards that could prevent stronger earnings growth from ending Wall Street’s extended summer dog days.

Earnings could turn corner even as Wall Street rally cools

Ironically, falling earnings earlier this year went hand in hand with a rallying stock market. The S&P 500 index (SPX) is up about 10% year to date as of early this week, mainly reflecting gains by the biggest mega-cap stocks amid excitement over artificial intelligence.

When the SPX goes up and earnings go down, it raises the market’s valuation, which in turn can dampen investor enthusiasm. The SPX’s forward price-to-earnings ratio (P/E) reached approximately 20 at its summer peak after starting the year near 17. It’s down slightly now at just under 18 and below the five-year P/E average. But it remains above the 10-year average of 17.5 and arguably has built in the anticipated improved earnings over the next year.

Another factor working against potential future market gains is the other side of the earnings equation: top-line growth, or revenue. Analysts expect revenue to grow for S&P 500 companies in Q3 but by just 1.6% and up just slightly from 0.9% in Q2. In contrast, Q3 2022 year-over-year revenue growth was above 10%, driven in part by soaring oil prices that resulted in a surge in energy company revenue. Still, four other sectors also recorded double-digit revenue growth that quarter, and just one sector (financials) accomplished that in Q2 this year. Analysts expect no sector to record double-digit revenue growth in Q3.

In Q2, companies saw revenue growth slow to 0.9% overall, thanks in part to declining inflation. Consumers appear to be pushing back on price hikes by either choosing cheaper places to shop or by pulling back on purchases of certain expensive goods like electronics and cars. This makes it more difficult for companies to grow revenue. 

The so-called “beat rate”—or the percentage of companies that beat Wall Street analysts’ revenue estimates—fell in Q2 to its lowest level in years even as many companies easily beat analysts’ earnings per share expectations by cutting costs. A similar dichotomy in the quarterly earnings season ahead could keep investors hesitant to fish out their rally caps.

Be careful following media coverage of earnings when the season begins in mid-October. Coverage on financial news networks often emphasizes horse race statistics surrounding which companies “beat” expectations, but investors should look beyond that if they want a full view of the landscape. Cost cutting can absolutely help bottom lines in a quarter, but if revenue stalls, a company might have trouble growing profit in the future. Net profit margin dipped to 11.6% for S&P 500 companies in Q2, from 12.2% a year earlier.

“Upcoming earnings season won’t be just about beat rates, but also the differential between bottom and top line,” wrote Liz Ann Sonders, chief investment strategist at Schwab, in a note last week.

There was a lot of excitement last earnings season about the high earnings “beat rate,” but with virtually no revenue growth, most of the earnings lift came through aggressive cost cuts. If revenues continue to decline, there would be minimal signs of strong demand, so earnings would be going up for the “wrong” reasons. That likely wouldn’t last in perpetuity, said Kevin Gordon, senior investment strategist at Schwab.

Another thing to track is “nominal versus real” earnings growth, Sonders wrote. Nominal versus real means adjusting companies’ results to account for the impact of inflation. A big revenue jump based on higher prices may be hard to repeat. Focusing on the nominal numbers can also give a skewed view of how well companies are actually doing. Many consumer-related companies reported higher revenue but fewer customers coming through the doors in recent quarters. Those who did shop had to pay up due to higher prices, but falling customer traffic might reflect resistance to pay more and falling product demand in general.

What to listen for

Earnings season doesn’t just tell you the top-line and bottom-line performance of companies. It’s an opportunity to hear directly from company executives about what issues they’re struggling with, bringing to mind the age-old old question, “What keeps you awake at night?” This coming batch of quarterly calls could help investors better understand how inflation, the struggling Chinese economy, rising energy costs, higher interest rates, and a tighter credit market are affecting businesses.

Inflation alert: Just 296 S&P 500 companies cited the term “inflation” during their Q2 earnings calls—the lowest since Q2 2021 and down from more than 400 that mentioned it during Q2 2022, FactSet noted. The improvement aligns with months of government data showing inflation deflating from the peak 9% levels seen in mid-2022. The question is whether companies are noticing the benefit, either through better margins or improved customer demand.

Oil can: The wild card is crude oil prices, which rose 16% from late August through mid-September to 10-month highs above $90 per barrel for WTI Crude Oil futures (/CL) on the CME Group. The crude gains are already having an impact on some companies’ bottom lines; both Delta DAL and American Airlines AAL delivered profit warnings in mid-September, citing the rising price of jet fuel. Worries turned toward the cost of diesel fuel as September continued, which could hurt margins for railroad and trucking firms that rely on that energy source.

Keep in mind, however, that the higher oil prices may not have a huge impact on Q3 results. While fuel costs form a healthy portion of airline expenses, they’re generally less of a factor now for both companies and consumers than they were 20 or 40 years ago. Energy and gas spending as a percent of consumption has been in a secular downtrend, Schwab’s Gordon said. Even during the 2022 oil pop, the percentage only went up to 3.3%, which was still half of what it was back in the 1970s.

China cart: It’s no secret that China’s post-pandemic economy hasn’t gotten out of the gate as quickly as many had anticipated. While China only accounts for about 5% of revenue for S&P 500 companies, according to Barron’s, some of the largest U.S. firms in the tech and communications services sector derive a higher-than-average percentage of their revenue from China. These include Apple AAPL, Microsoft MSFT, Nvidia NVDA, Tesla TSLA, and several others whose cumulative rally this year is responsible for more than half of the SPX’s gains, Barron’s reported. China’s flagging economy isn’t the only worrisome factor here. The tit-for-tat sanctions and bans on semiconductor chips and other key technology as the economic battle persists between China and the United States could ultimately hurt the major companies. Earlier this month, Apple shares fell on news that China was banning government workers from using iPhones at their offices. Expect earnings season to help shed light on China’s impact.

Helping hand: Payroll growth has slowed considerably since the post-pandemic reopening phase in 2021. Looking at the three-month average of monthly job gains, the fall to 150,000 for the three months ending in August marked the lowest since the COVID-19 pandemic began in March 2020. Earnings season often coincides, for better or worse, with company layoff announcements, so be on the lookout. Executives on company earnings calls may also be asked about hiring trends and the jobs outlook in their industry.

Santa Claus: This earnings season is a chance to hear from retail companies about how they see Christmas shopping shaping up. The big boxes like Target TGT, Walmart WMT, and Best Buy BBY, along with internet retailers like Amazon AMZN and consumer-facing tech firms like Apple, are all likely to provide guidance on the holiday period straight ahead. Consumer spending makes up 70% of the U.S. economy and Q4 is when retailers traditionally rack up a chunky portion of their sales. Stay tuned.

Bottoms up: As a final reminder, analysts usually err toward the conservative side with their earnings estimates going into a quarter. For instance, they anticipated earnings would be down 7% entering Q2 earnings season but the actual quarterly decline turned out to be just 4.1%, according to FactSet. If analysts’ previews of Q3 miss by the same amount, Q3 might turn in earnings growth of around 3%. Check back in November.

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

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