Investors have all the excuses not to act, as most assumptions await confirmation. First, the geopolitical power game is in full swing, with further US technology bans against China. Second, China’s coming policy milestones, if any, are expected next week at the earliest.

Third, there will be another litmus test for the rollover of inflation when the latest data is published this week. Fourth, and most importantly, the earnings season starts on Friday, with the large US banks reporting first. This round of reporting will likely be quite an odd one, for hardly any analyst active today has ever been through the monster inflationary wave that we have witnessed in the past few quarters.

For the economy, this means real growth in the low single digits, while nominal growth is north of 10% globally. For corporates, it means that sales are surging due to the price bulge, although the biggest question is who can protect margins as costs skyrocket.

The past rounds of earnings reports already showed slowing earnings growth, while sales growth kept ploughing ahead. This time around, consensus goes for +6% sales growth for US stocks, excluding oil & gas, while earnings should contract by -4%.

Of course, it is all about a reality check. And while a drop in earnings will not be a game changer, there may be quite some shifts below the surface. Oil & gas stocks are expected to double their earnings, while communications and financials are expected to shed circa 15% of their earnings. In the meantime, we will stick to housekeeping until the evidence is in.

We have tuned up our short- and medium-term yield forecasts for US Treasuries to 3.65% and 3.70%, respectively, as the US economy shows strong resilience against rising rates. As for currencies, we have moved forward the rollover in USD strength against the EUR, as European rates will have further room to go in 2023. Despite all the ‘known unknowns’ in earnings, we say ‘enough is enough’ when it comes to European utilities and have upgraded the sector on valuation and dividend prospects. Finally, in the information technology sector, we reiterate our preference for software over semiconductor stocks.

A closer look at earnings season

With recession risks on the rise, investors are increasingly focusing on the earnings resilience of corporates. Thus, the upcoming earnings season will be closely watched. 

Early reporters are usually a good indication of the actual results of the companies within the S&P 500. From the handful of companies that have reported so far, only 55% have beaten earnings expectations, the lowest since Q1 2019. This compares with a 10-year average of 69%. Usually, such a reading is consistent with a slight earnings miss ahead.

Consensus has already adjusted to the deteriorating macro backdrop by trimming its Q3 earnings growth estimates by 7% to 2.3% over the past three months, driven by earnings cuts in all sectors except oil & gas. Excluding the oil & gas sector, which experienced upside revisions, earnings for the S&P 500 are expected to contract by 3.9% compared to Q3 last year. Also profit margins have been revised down, to 12.2% (Q2: 12:4%), as still elevated inflation supports top-line growth but translates into a headwind for margins.

Unsurprisingly, consensus expects much higher sales growth (+8.5%) than earnings growth (+2.3%). We are less concerned about the Q3 results as such, given the sharp drop in Q3 expectations, and more concerned about below-consensus guidance for Q4 and 2023. After a temporary blip, consensus expects profit margins to reach prior record-highs of 12.7% by Q3 2023, driven by labour-intensive sectors such as industrials and consumer cyclicals.

This seems rather unlikely, in our view, and we expect 2023 guidance to disappoint and earnings to be revised down, led by cyclical sectors. Going forward, a focus on companies with high pricing power and cash flow generation seems more important than ever.