The U.S. equity market has already factored in a lot of bad news so far this year: a spike in inflation to its highest level in 40 years; the start of the Fed’s most aggressive rate hike campaign since the early 1980s; weakening domestic and global economic activity; skepticism about corporate earnings growth; military hostilities in Ukraine; commodity price spikes related to Western sanctions on Russia; the first stage of a European energy crisis; and renewed supply chain and growth concerns stemming from China’s strict measures to control COVID-19.
So it’s little wonder that the S&P 500 and Nasdaq Composite dropped 23 percent and 32 percent, respectively, from the start of the year through mid-June, before bouncing nicely on better-than-feared Q2 earnings results and as Treasury yields backed off of their recent peak levels.
The S&P 500 has rebounded off its mid-June low (YTD % change)
Line chart showing the performance of the in the S&P 500 Index from January 1, 2022 through July 25, 2022, relative to its level on December 31, 2021. The Index’s all-time high on January 3 was followed by a decline through the end of January due to inflation and concerns about Federal Reserve interest rate hikes. On February 11, the market started factoring in Russia-Ukraine risks, and fell 5.6% between that date and its low point on March 8. In total, the market declined 13.1% by March 8 on a year-to-date basis. The market subsequently rebounded and surpassed its February 11 level by March 18, recouping the losses from the military intervention. From April through mid-June the market recorded its biggest pullback so far this year, reaching a low point on June 16, down 23.1% year to date. Since then it has bounced, regaining some of that lost ground. As of August 1, the S&P 500 was down 13.6% year to date.
Source - RBC Wealth Management, Bloomberg; daily data through 8/1/22
While the worst blows to the equity market seem like they are in the rearview mirror, we question whether an outright decline in corporate profits, typically associated with recession periods, has been fully priced into the S&P 500 and other major indexes.
When the Federal Reserve hikes interest rates, there is normally a lag of some months before higher borrowing costs begin to weigh on U.S. economic activity; any additional weakness in the consumer and service segments of the economy could pose challenges for S&P 500 earnings growth in coming quarters. With two consecutive quarters of GDP declines already in the books, and risks of an official broad-based recession having risen, we think it prudent for investors to weigh various earnings scenarios—including the typical impact of an economic contraction on corporate profits.
Q2 earnings season provides some hints
First things first: Consider the developments during the ongoing Q2 earnings season, as there are signals about how the earnings trajectory could unfold in future quarters. With 64 percent of S&P 500 companies having reported Q2 results so far …
- Earnings growth is pacing at 8.1 percent year over year, higher than the 5.5 percent consensus forecast at the start of earnings season. S&P 500 profit margins have pulled back 4.8 percent year over year (-9.8 percent excluding Energy).
- Many companies have posted strong results, and some have benefited from pricing power due to inflation. However, there also have been high-profile misses and/or reduced forward guidance from the likes of Allstate, AT&T, Capital One Financial, Intel, IBM, JPMorgan Chase, Meta Platforms (Facebook), Procter & Gamble, Verizon, and Walmart, among others. Big misses happened during the Q1 reporting season as well.
- The earnings surprise level (the amount by which S&P 500 earnings growth exceeds the consensus forecast) has dropped back near the pre-pandemic average; this is to be expected.
Earnings beats have moderated to a more normal level
Historical S&P 500 quarterly earnings beat rate and thus far for Q2 2022 (percentage point beat above the consensus forecast)
Column chart showing the quarterly S&P 500 earnings “beat rate,” which is the amount by which actual reported earnings exceed the consensus forecast for the quarter, in percentage points, from the first quarter (Q1) of 2017 through the second quarter (Q2) of 2022 (preliminary result as of August 2, 2022). From Q1 2017 through Q1 2020 (the period before COVID-19 impacted earnings estimates), the beat rate averaged 4.9%. During pandemic-related shutdowns and in the initial aftermath, when estimates and beat rates were distorted by the pandemic, the beat rate was much higher, ranging from about 9.7% to 23% from Q2 2020 through Q3 2021 (average was 17.5%). Since then, the beat rate has drifted down, first reaching about 5.5% in Q4 2021, and dropping further to 4.5% thus far in Q2 2022.
Source - RBC Wealth Management, national research correspondent, Refinitiv I/B/E/S, FactSet; data as of 8/2/22. Q2 2022 data (red vertical bar) is preliminary.
Overall, we view this as a solid earnings season thus far, especially given the headwinds. But when margins compress and high-profile earnings misses mount in a variety of sectors for two straight quarters, this typically signals that analysts’ estimates have become loftier and more challenging to clear, and/or that the earnings growth cycle is entering a later, more mature phase. We think all of these factors are in play, and are signs the growth cycle is losing momentum. This is actually normal given the more challenging economic backdrop.
Are consensus earnings estimates too high?
It’s notable that the consensus earnings forecasts of Wall Street industry analysts for 2022 and 2023 assume earnings will steadily increase. It’s as if the tumultuous events of the past months hadn’t happened or would have no consequences for profits going forward. We think the 2023 consensus estimate assumes a soft landing for the U.S. economy—in other words, no recession.
Are earnings estimates too optimistic?
S&P 500 quarterly earnings per share: actual in dark blue, consensus estimates in light blue
Column chart showing quarterly S&P 500 earnings per share since 2019. The actual results are from Q1 2019 through Q1 2022, and the consensus estimates are from Q2 2022 through Q4 2023. Earnings rose slightly until Q4 2019 to almost $42 per share. Then they plunged in Q1 and Q2 2020 due to COVID-19, falling to a low point of roughly $28 per share. Since then, they have steadily gained, rising to almost $55 per share in Q1 2022. The consensus forecast estimates that earnings will rise this year and next, reaching $64 per share in Q4 2023.
Source - RBC Wealth Management, Refinitiv I/B/E/S; data as of 8/2/22
Is this an all-clear signal? Not so fast—there are a few complicating factors to consider.
Since the global financial crisis in 2008 and 2009, company management teams have become more cautious with their forward earnings estimates. They have little incentive to go out on a limb, especially when economic prospects become more uncertain. And compared to years ago, a higher proportion of companies are reluctant to disclose their forecasts beyond the next quarter, let alone for the next year. This means Wall Street industry analysts have less formal corporate guidance to work with than they used to. Consequently, when the economy wobbles and weakens, as it’s doing now, we think consensus estimates become less useful as guideposts.
Based on the wide range of research we monitor from internal and external equity market strategists, anecdotal evidence leads us to believe that institutional investors—portfolio managers who oversee mutual funds, pension funds, and hedge funds—are not confident in the current consensus forecasts. We think their expectations, collectively, lie somewhere between the consensus forecasts and the recently revised RBC Capital Markets estimates, which are much more conservative.
RBC’s earnings estimates are much more conservative
S&P 500 EPS: actual and estimates
Column chart showing historical and estimated S&P 500 annual earnings per share. In 2021, the S&P 500 delivered $208 per share in earnings. For 2022, the consensus forecast is $226 per share, whereas the RBC Capital Markets forecast is $214 per share. For 2023, the consensus forecast is $245, whereas RBC is estimating $212.
Source - Refinitiv I/B/E/S, RBC Capital Markets U.S. Equity Strategy; data as of 8/2/22
In terms of the market, we think it’s actually good news that institutional investors are skeptical of the consensus forecasts, because it suggests the S&P 500 is already discounting earnings growth that is less robust than those levels. Institutional investors’ doubts about earnings growth likely contributed to the market selloff from April to mid-June, meaning some degree of earnings pessimism has been factored into stock prices.
It’s worth taking a closer look at RBC Capital Markets estimates, especially the 2023 earnings-per-share (EPS) forecast of $212, as it assumes that earnings basically go nowhere from 2021 to 2023.
Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, LLC, derived this estimate by taking into account a number of inputs, including both corporate fundamentals and macroeconomic factors. Her 2023 forecast assumes, first of all, that S&P 500 revenues keep growing, but that profit margins take a hit later this year and next year. It also assumes the U.S. economy comes close to contracting in Q4 2022 on a year-over-year basis, then experiences sluggish growth of one percent to two percent in 2023, and that inflation comes down from its peak but remains elevated for much of next year. Calvasina anticipates the Fed will start cutting interest rates in the first half of next year.
Following a strong 12.3 percent bounce off its mid-June low, the S&P 500’s price-to-earnings (P/E) ratio now stands at 19.4x based on Calvasina’s 2023 estimate. While this isn’t overly expensive, in our view, it is not inexpensive and is above the historical average. The S&P 500’s forward P/E multiple has averaged 16.2x over the past 10 years and 15.3x since 1990.
Profits normally retreat during recessions
When considering earnings scenarios, we also find it informative to review historical earnings trends during previous economic downturns that were officially declared to be recessions by the National Bureau of Economic Research. Regardless of whether the present episode ultimately receives the official title, RBC Capital Markets, LLC’s Chief U.S. Economist Tom Porcelli says, “things are already feeling recessionary.”
Surrounding the previous 11 recession periods since the 1950s, RBC Global Asset Management found that S&P 500 earnings fell 23.6 percent, on average. But there are nuances.
Excluding the two periods associated with unique financial system turmoil (1990, 2007) that caused overall S&P 500 earnings to decline severely, the average retrenchment was 18.9 percent. We think there are legitimate reasons to set aside these two periods: there are currently no signs of financial system stress, according to a wide range of measures; and U.S. bank balance sheets appear sturdy enough to withstand the increase in loan losses that accompanies most recessions.
If we focus on just the four recession periods associated with inflation shocks (1953, 1973, 1980, 1981), we see an average earnings decline of 17.7 percent. Because some companies are exhibiting inflation-related pricing power during this earnings cycle even as the economy slows, thus maintaining strong revenue growth, we think these periods are useful guideposts. Accordingly, investors should not rule out the possibility that earnings could retreat 10 percent or more from peak to trough, similar to prior inflationary periods.
S&P 500 earnings retreated in each of the prior 11 U.S. recessions
Periods that coincided with inflationary shocks highlighted in red
Source - RBC Global Asset Management
When might the earnings peak arrive? It could happen in the current Q2 reporting period, or during the Q3 or Q4 reporting seasons, or even early next year, depending on when and how economic activity decelerates.
Calvasina has modeled a full-blown recessionary scenario in which the economy contracts for several quarters on a year-over-year basis, but at a milder rate than it did during the three most recent recessions. In that case, she forecasts that S&P 500 earnings would fall to $195 per share in 2023. This estimate is within the zone of previous peak-to-trough earnings retrenchments during inflationary recession periods.
Uncertain, but not unmanageable
In summary, while we think the bulk of the equity selloff and market risks are likely behind us, it may take more time to reveal whether the economic and earnings vulnerabilities have been fully incorporated into stock prices.
The good news for investors is we don’t think that the market is currently assuming the lofty consensus earnings forecast for 2023 will play out, and instead seems to be expecting a less-rosy scenario.
We believe Calvasina’s much more conservative $212 per share estimate for 2023 leaves little room for upside. Basically, her earnings estimates call for range-bound market action through the end of this year, with some downside risk.
Investors should also consider the possibility that a full-blown recession could cause a bigger retrenchment in earnings, similar to those that have occurred during previous inflation-driven recession periods.
At this stage, we recommend maintaining U.S. equity exposure at the Market Weight level. Many of the risks seem to be reflected in stock prices, but investors should bear in mind that there could be more volatility or downside as the economy finds its path and the corporate earnings picture becomes clearer.