Looking Beyond Q3 Earnings

11.2.2023 Third quarter 2023 marks the end of the earnings recession. The current quarterly earnings reporting season represents the first annual profit gain since last year, with negative comparisons beginning in Q4/22. S&P 500 profits are on track to have grown 2.8% over the last 12 months. Despite the headlines, investors’ reaction to last quarter’s earnings reports have been as exciting as cold mashed potatoes. Alphabet, the company behind Google, handily beat profit expectations but its shares plunged 10 per cent as investors reacted to the company’s disappointing cloud-computing results. Social media company Meta also beat, but its stock was punished for management’s dour macroeconomic outlook. Meanwhile, consumer product firms, like Coke and McDonalds, offered positive revenue growth, but the inflation-adjusted numbers suggest volumes were lackluster. So far, S&P 500 stocks whose 3Q earnings results fell short of investors’ expectations dropped 5.5 per cent in the days following their earnings announcement. That’s far worse than the five-year average of 2.3 per cent, according to the Financial Times. Looking out over the next few quarters, the health of consumers is the biggest worry in corporate C-suites. That’s because more than one-third of corporate revenues are derived from consumer spending, according to The Economist. While the consumer spending picture is bright, clouds are forming on the horizon.

US consumers emerged from their lockdown lairs with their wallets wide open, and still haven’t closed them. Retail sales activity expanded a whopping 0.7% in September, marking the third consecutive month of strong sales. Consumers visited retail stores, bought new and used automobiles and dined out.  For the three months ended in September, retail sales grew at an annualized 6.4 per cent, the most impressive quarterly advance since June 2022. Spending was powerful enough to fuel strong economic growth last quarter. The Bureau of Economic Analysis report on the economy showed Q3/23 GDP expanded at a 4.9 per cent annualized rate, its best showing since Q4/21 – the period during which vaccinated consumers stampeded back into the stores. 

We see several early warning signs that suggest that America’s spending spree could be winding down.  Spending growth has outpaced income growth in five of the last six months, reversing a trend, as wage growth is beginning to lose steam. Households are increasingly relying on credit cards to bridge the gap. Card balances have expanded 9.7 per cent over the last four quarters through September to $1.3 trillion, according to Federal Reserve data. Meanwhile, credit card delinquencies are on the rise, with 1.2 per cent of balances outstanding more than 30 days past due. Stocks of the three consumer credit agencies, Experian, Equifax, and TransUnion, have fallen sharply in recent weeks, suggesting a slowdown in consumer credit activity. Consumer confidence, a useful predictor of retail purchase activity, is falling. However, as we discussed in our note last week, wealthy consumers, including seniors, might keep spending. These cohorts, which represent nearly half of discretionary spending, are somewhat insulated from higher borrowing costs (they don’t borrow) as well as the job market (a growing share of Boomers are retired).   

Higher rates are already pinching certain segments of the economy. The housing market, comprising 10 per cent of economic growth, is retrenching in response to higher mortgage rates. Sales of existing homes are sliding toward levels not seen since 2010. Meanwhile, smaller firms – most of which are saddled with floating rate debt – are feeling the pinch of higher financing costs from either banks or private lenders. The Economist estimates there’s nearly $3 trillion of floating-rate debt outstanding. The New York Times reported that interest payments by small businesses will rise to about 7 seven per cent of revenues next year, up from 5.8 per cent in 2021.

Bottom Line: Domestic demand is strong, but equity investors are beginning to look through today’s impressive results toward slower growth 2024. While a lower earnings growth trajectory poses an equity market risk, if the slowdown is coupled with lower interest rates, any reduction in earnings growth would likely be offset by stable or expanding multiples.