What to watch for as Q3 earnings season begins

With an economy struggling with high inflation, aggressive rate hikes from the Federal Reserve and growing risks of recession in 2023, the third quarter earnings season will be crucial for the broader market and individual companies. Expectations heading into this reporting season are low, with earnings expected to grow less than 3% year-over-year. Headlines weighing on earnings remain the same as last quarter, including slowing economic growth, rising labor and input costs, Ukraine, China’s zero-Covid policy, supply chain and a strong dollar. Additionally, Hurricane Ian could have caused disruption at the end of the quarter and will no doubt start to result in losses for some insurance companies. As usual, actual performance should beat earnings estimates, but forecasts will be crucial with significant concerns about the deteriorating economic outlook and cost pressures. The ability of companies to pass on higher prices to protect their profit margins will remain a critical variable.

15 S&P 500 companies are expected to report earnings this week, but the main focus will be on financials and banks in particular. There are a handful of other companies like Pepsi (PEP), Delta Air Lines
DAL
(DAL), Fastenal
QUICK
(FAST), BlackRock
noir
(BLK) and UnitedHealth (UNH) on the schedule. Reporting banks include JPMorgan Chase
JPM
(JPM), Morgan Stanley
MRS
(MS), PNC (PNC), U.S. Bancorp
TBBK
(USB), Citigroup
VS
(C) and Wells Fargo
WFC
(WFC), the results will therefore provide financial results and a good idea of ​​the operating environment. According to FactSet, financial data is expected to be near the bottom of earnings growth rates, with consensus estimates for year-over-year earnings showing a decline of -12% at the end of the quarter.

Concerns about future economic growth led bank stocks to underperform this year, but bank stocks outperformed in the third quarter thanks to a sharp rise in interest rates. Positives from the earnings reports should be better net interest income, net interest margins (NIM) and loan growth. The NIM is the amount a bank earns in interest on loans relative to the amount it pays in interest on deposits, which is expected to be helped by rising rates. On the other hand, banks are likely to increase their loan loss reserves to prepare for the increase in future credit losses that would accompany a possible recession. These reserves should be earmarked for future loan losses, as credit trends will likely remain healthy. These growing provisions for loan losses are making the decline in earnings worse than it otherwise would be. Other negatives are expected to include lower investment banking revenue, reduced mortgage banking, higher costs and lower wealth management fees due to the market decline. In summary, core banking and credit should remain in better shape than overall earnings suggest.

The energy sector is set to benefit massively from higher energy prices, with profits expected to rise more than 100% year-over-year, while sales are up more than 30%. Some investors remain positive on the sector as regulatory filings showed Berkshire Hathaway
BRK.B
continued to buy shares of Occidental Petroleum
OXY
(OXY) in the last week of September and now owns approximately 21% of the company. A previous article explained why Warren Buffett’s Berkshire Hathaway might add to his holdings in Occidental Petroleum.

Although sales growth may seem high for the quarter, the result will be flattered by the high rate of inflation. Sales growth is closely related to nominal GDP growth, which combines economic growth after inflation (real GDP) and inflation. With nominal GDP growth expected to be around 7.5% YoY in the third quarter, the consensus estimate of 8.7% YoY sales growth for the S&P 500 looks achievable.

A simple model looking at the differential in producer input price (PPI) growth relative to price increases hitting consumers indicates increased pressure on profit margins. As a result, high single-digit sales growth in the S&P 500 is expected to translate into low single-digit earnings growth.

Oil prices rose sharply in the third quarter, but the pace of year-over-year gains fell by more than 60% in the second quarter. While the sharp rise in energy costs is benefiting the energy sector, the more than 30% year-over-year increase in the average oil price for the quarter is having a negative impact on costs many non-energy companies. Again this season, the impact of rising costs and the ability to pass on higher prices to protect profit margins will be closely scrutinized across all businesses. Labor costs will be a headwind for businesses, with average hourly compensation rising at a 5.0% year-over-year rate in September. Rising labor costs are offset by the fact that companies have created only 0.3% more jobs than the pre-Covid peak, while economic activity is well above the pre-Covid levels.

Although overseas shipping costs have exceeded peak levels, transportation and freight prices remain high as fuel and wage costs continue to exert pressure.

Additionally, a change in consumer needs for certain goods has caused some retailers to carry excess inventory. The demand for goods relative to services has increased during the pandemic, and this trend appears to have started to reverse back to a more normal balance. Weaker demand for goods and discounts due to bloated inventory will likely put pressure on earnings for retailers in the consumer discretionary sector.

This week’s reading of consumer inflation (CPI) for September, combined with the resilience of the labor market highlighted by last week’s employment report, is unlikely to assuage concerns over increases. of costs. The CPI is expected to increase to 8.0% year-on-year. Although this reading is below June’s 9.1% level, the level of persistent inflation is likely to remain uncomfortably high. Rising prices faster than wages are a recipe for lower demand after inflation, which adds pressure on growth. Earnings are reported in nominal terms, so it should be noted that they are expected to decline year over year after accounting for inflation. A print of elevated inflation combined with continued strength in the labor market, as evidenced by the 3.5% unemployment rate reported last week, is expected to result in a 75 basis point (0.75%) rise. of the Federal Reserve in November a virtual certainty.

Earnings of companies doing business abroad will be negatively impacted by the continued strength of the US dollar. With roughly 40% of S&P 500 company sales coming from international sources, this negative drag on dollar strength is likely to be a constant refrain.

Earnings are expected to rise less than 3% year-over-year, which would be a drop if you take inflation into account. Actual earnings are expected to beat estimates, but forecasts will be even more critical with ongoing concerns about aggressive Federal Reserve rate hikes weighing on the economic outlook and continued cost pressures.

About Mary Moser

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