Ahead Of A Subpar Earnings Season: “Investors Are Wary That Companies Might Low-Ball 2023 Guidance”
Next Friday, financials will kick off what is expected to be a lackluster 4Q 2022 earnings season, and by February 10th, companies representing 77% of S&P 500 market cap will have reported year-end results.
According to Goldman’s David Kostin, consensus expects the aggregate S&P 500 index will post 0% EPS growth in 4Q 2022 vs. 4Q 2021: i.e., flat, as S&P 500 earnings growth decelerated from +12% in 1Q to just +3% in 3Q. If consensus expectations for 4Q were to materialize, it would represent the weakest quarter of growth since 3Q 2020. However, earnings growth forecasts are disparate at the sector level.
Once again, consensus is most optimistic on Energy EPS (+63%) and most pessimistic on Comm Services (-22%) and Materials (-20%). S&P 500 ex. Energy EPS is expected to fall 5%. Industrials is also expected to post strong growth (+36%), although we recently reiterated our underweight recommendation in the sector due to recent outperformance and decelerating capex in the near term.
Unlike flat EPS, S&P 500 revenues are expected to still grow by 8% year/year, with all sectors positively contributing. That’s because according to Kostin, nominal economic growth has remained strong and explains most of sales growth in Goldman’s top-down model. Furthermore, the recent 4% decline in the trade-weighted dollar represented a declining headwind for the translation of foreign sales since approximately 30% of S&P 500 sales are generated internationally (indeed, since the start of 4Q, Goldman’s International Sales basket (GSTHINTL) has outperformed the Domestic Sales basket (GSTHAINT) by 16 pp (+21% vs. +5%).)
On the other hand, the outlook for profit margins is deteriorating: S&P 500 margins contracted year/year for the first time in 3Q (-45 bp) and analysts expect this degradation to accelerate in 4Q (-81 bp to 11.2%). At the sector level, Energy is expected to expand margins the most (+364 bp) while Communication Services is expected to contract back to its lowest level since 3Q 2015 (-475 bp to 12.4%). Excluding Energy, S&P 500 margins are estimated to contract 134 bp to 11.0%.
So where does that leave us?
According to Kostin, with 2022 behind us, investors are now primarily focused on the profit outlook for the coming year. As a reminder, Goldman – which has traditionally been dead wrong in its year-ahead market forecasts – expects flat annual EPS growth compared with bottom-up consensus expectations of +3%. The gap reflects the bank’s assumption of greater margin compression than consensus expects. Excluding Energy, which benefits from high commodities prices and capital control, the bank expects that S&P 500 profit margins in 2023 will fall by 50 bp to the pre-pandemic levels of 11.3%
Additionally, as per Kostin’s recent client conversations, some skeptical investors are wary that managements might low-ball 4Q results and 2023 guidance. This even as more than 20% of S&P 500 market cap has preannounced in 4Q 2022, the highest share since 1Q 2020. Similarly, the 3-month trend of S&P 500 FY2 EPS revision sentiment stands at -31%, the most negative reading outside of the 2008 and 2020 recessions
In his latest Weekly Kickstart notes, Kostin highlights one upside and three downside risks to 2023 EPS… though on net, he sees greater downside risks and expect further negative revisions.
1. Recent easing of China’s zero-COVID policy represents one upside risk to S&P 500 profits via stronger 2023 global growth. A 100 bp increase in world GDP growth would increase Goldman’s top-down EPS forecast by 100 bp; at the same time, the bank’s China economists estimate that a faster-than-expected exit from zero-COVID suggests weaker near-term growth. TSLA recently reported disappointing vehicle deliveries in 4Q 2022, partly due to softer China demand. However, the new policy has broadly boosted growth expectations for FY 2023. Since the start of 4Q, a basket of stocks with high China sales exposure (GSXUCHSE) has outperformed stocks with high domestic sales exposure (GSTHAINT) by 8 pp (+13% vs. +5%)
2. Weak consumer demand would limit firms’ pricing power and pressure profit margins. Store traffic for the 2022 holiday season remained muted relative to 2019 levels and early sales results point to soft consumer spending. OLLI missed estimates stemming from lower-than-expected customer demand; while DRI’s commentary on the consumer was relatively positive, the deceleration in high-end consumer spending could be early signs of easing demand. Within Info Tech, AAPL was reported to order fewer parts from suppliers and Semis analysts have warned that the demand environment will likely remain impaired for MU through the beginning of 2023. Consumers have also become increasingly incentivized by promotions and higher promotional intensity is expected to pressure gross margins.
3. Corporate tax policies taking effect in 2023 should have a small hit to aggregate S&P 500 earnings, but the impact will vary across sectors. The Inflation Reduction Act imposes a 15% minimum tax on corporate book income and a 1% excise tax on buybacks. These new corporate taxes, however, should reduce aggregate S&P 500 EPS by less than 2%. The minimum tax should reduce S&P 500 EPS by roughly 1%. However, sectors with the lowest effective tax rates, such as Info Tech and Health Care, will face a larger impact. The buyback excise tax would reduce S&P 500 EPS by 0.5%, assuming no change in repurchase activity. The 2017 Tax Cuts and Jobs Act introduced R&D amortization and tighter limits on interest deductibility, which took effect in 2022. Capex deduction will begin to phase out, from 100% to 80% in 2023. Goldman estimates that all these provisions would lower 2023 S&P 500 EPS by 3% if they were to take effect.
4. The biggest risk in 2023 is a potential recession, in which case S&P 500 EPS could fall by 11% to $200 and the index could trough at 3150 (-19%). Goldman Sachs economists assign a 35% probability that the US economy enters a recession during the next 12 months, significantly below the consensus forecast probability of 65%. The bank had previously outlined a recession earnings scenario, which assumes the US economy modestly contracts. Concentrated sector weakness could lead to larger EPS declines than its current forecast. For example, S&P 500 EPS fell by 20% in 1990 mainly due to Autos, 23% in 2001 due to Info Tech, and 45% in 2008 due to Financials. The next chart shows a breakdown of bottom-up consensus and our top-down baseline and recession 2023 EPS forecasts by sector.
More in the full note available to pro subs.
Mon, 01/09/2023 – 06:55