What to watch as the second quarter 2023 earnings season gets underway

Outlook is low for a challenging second quarter earnings season with economic growth slowing year on year and the effects of high inflation still being felt. Earnings are set to decline -6.8% yoy and primary sales are expected to see an uneven contraction of -0.4%. If analysts are to be believed, this quarter should point to the decline in earnings contraction, with consensus estimates suggesting that year-over-year earnings growth will resume for the third quarter. The companies’ ability to pass on higher prices to protect margins will continue to be a critical variable. While the risk of a recession has receded in the next few months, the situation remains unstable, as the Federal Reserve is expected to resume raising short-term interest rates in July. Given the uncertain economic outlook and current expectations for earnings growth to resume next quarter, future guidance will be critical.

Twelve companies on the S&P 500 are scheduled to report earnings next week, but the main focus will be on banks starting earnings on Friday. There are few other companies like Delta Air Lines
(DAL), BlackRock
(BLK), PepsiCo
(PEP) and UnitedHealth (UN) are on the calendar. Among the banks that reported was JPMorgan Chase
(JPM), Citigroup
(C), State Street (STT), and Wells Fargo

According to FactSet, the consolidated annual earnings estimate for the financials is up 5.3%. While the worst of the banking crisis has passed, the cost of deposits and losses from commercial real estate loans will be watched closely. The pace of loan growth has slowed, which may affect future earnings expectations. While net reductions from loan losses should remain very low this quarter, banks are likely to increase their reserves this year to prepare for future losses. For more information on the US banking system, including stock valuation, the latest update is available here.

The consumer discretionary segment is expected to register the highest growth rate year-on-year at 26.1%. This increase is primarily due to Amazon
.com (AMZN), which posted a loss in the second quarter of 2022 but is expected to post a profit for the same period this year. With Amazon accounting for more than 20% of the segment’s total market capitalization, its results have a significant impact on the industry.

Oil and natural gas prices fell sharply year-on-year, leading to the expected decline in the annual revenues of the energy industry. With the sharp contraction in sales, energy companies are expected to see the largest drop in their profits year-over-year this quarter. While the decline in energy costs hurt energy sector revenues, the more than 30% year-over-year decline in the average oil price for the quarter positively impacts costs for many non-energy companies. Labor costs will be a headwind for businesses, with average hourly earnings rising at a 4.4% year-over-year rate in June.

Despite the expected drop in earnings for the quarter, some investors remain positive on the sector as regulatory filings showed Berkshire Hathaway
(BRKA, BRKB) bought more from Occidental Petroleum
(OXY) in June and now owns more than 25% of the company. An earlier article discussed why Warren Buffett’s Berkshire Hathaway preferred Occidental Petroleum.

Sales growth is usually closely related to nominal GDP growth, combining economic growth after inflation (real GDP) and inflation. While nominal GDP growth is likely to continue its slowing yoy trend for the second quarter, the consensus estimate of -0.4% yoy shrinking sales for the S&P 500 looks beatable.

Unfortunately, most of the projected growth of nominal GDP is inflation rather than actual growth. Inflation has been trending downward since mid-2022 but remains above the 2% target. Inflation pressures companies to raise prices or risk lower profit margins as their costs rise.

A simple model that looks at the difference in price growth for producer inputs (PPI) versus price increases hitting consumers suggests some relief in profit margins may be on the way. While the model shows that the situation should improve, feeding through the system will take some time. Slow growth coupled with limited ability to increase prices to slump demand is expected to result in a mid-single-digit drop in earnings growth year-over-year.

Finally, the US dollar offered some relief, as the currency’s relentless strength took a toll on profits for companies doing business offshore. Since approximately 40% of S&P 500 companies’ sales come from international sources, removing significant negative barriers is likely to boost companies that sell products internationally.

The lower forecast of a -6.8% yoy decline in earnings seems likely to be exceeded, but more attention needs to be paid to management’s future earnings guidance. With the consensus expecting this reporting period to be the lowest, there is a risk if companies indicate the need for additional cuts to earnings projections. There are positive signs that a resilient labor market, improving inflation and a stable banking system make a recession in the next few months less likely. However, the specter of recession remains, given the strong signal from the inverted yield curve. Finally, given the hype around the technology and strong stock returns, earnings growth from artificial intelligence (AI) applications will be closely scrutinized.