With the economy laboring under elevated inflation and companies up against difficult comparisons with last year, the fourth-quarter earnings season will be challenging for the overall market and individual companies. Expectations going into this reporting season have been slashed, with earnings slated to decline at more than -4% year-over-year. The items weighing on earnings include slowing economic growth, rising costs, and a strong dollar. The ability of companies to pass on higher prices to protect profit margins will remain a critical variable. Expectations for this quarter plunged since the end of the third quarter so that actual performance could exceed the relatively low earnings estimates despite all the headwinds. With the aggressive Federal Reserve rate hikes, cost pressures, and rising risks of a recession in 2023, forward guidance will be crucial.
Nine S&P 500 companies are scheduled to report earnings this week, but the primary focus will be on the financials and the banks in particular. There are a handful of other companies like Delta Air Lines DAL (DAL), BlackRock BLK (BLK), and UnitedHealth (UNH) on the calendar. Among the banks reporting are JPMorgan Chase JPM (JPM), Citigroup C (C), First Republic Bank FRC (FRC), Bank of New York (BK), Bank of America BAC (BAC), and Wells Fargo WFC (WFC), so the results will provide financial results and a good idea of the operating environment. According to FactSet, the consensus year-over-year earnings estimates for financials are showing a decline of -12.2%. While the banks’ capital markets and wealth management businesses should be a drag, the strength of the core lending business, along with the status of credit losses, will be of interest.
The energy sector continues to be a massive beneficiary of increased energy prices, with earnings slated to increase by over 60% year-over-year while sales grew by almost 34%. Some investors remain positive on the sector as regulatory filings showed that Berkshire Hathaway BRK.B bought shares of Occidental Petroleum OXY (OXY) last year and now owns more than 20% of the company. A previous piece discussed why Warren Buffett’s Berkshire Hathaway probably favors Occidental Petroleum.
While the sales growth may seem elevated for the quarter, the high inflation rate boosts the result. Sales growth is closely tied to nominal GDP growth, which combines the after-inflation economic growth (real GDP) with inflation. With nominal GDP growth expected to be in the high single digits year-over-year for the fourth quarter, the consensus estimate of 3.8% year-over-year sales growth for the S&P 500 looks very achievable.
Unfortunately, most of the expected nominal GDP growth is inflation rather than actual growth.
A simple model looking at the differential in price growth for producer’s inputs (PPI) versus the price increases hitting consumers indicates continued pressure on profit margins. Hence, the mid-single-digit sales growth for the S&P 500 is expected to result in a decline in earnings growth year-over-year.
Despite the price of energy commodities falling in the fourth quarter, the year-over-year prices of oil and natural gas were higher. While the sharp increase in energy costs benefits the energy sector, the over 10% year-over-year increase in the average oil price for the quarter negatively impacts the costs for many non-energy companies. Again this season, the impact of higher costs and the ability to pass on higher prices to protect profit margins will be closely scrutinized across all companies. Labor costs will be a headwind for companies, with average hourly earnings rising at a 4.6% year-over-year rate in December. Offsetting higher labor costs is the fact that companies have only added 0.8% more jobs compared to the pre-Covid peak, while economic activity is well above pre-Covid levels.
Overseas shipping costs have returned to normal levels, so that should be positive. Transportation and freight prices remain high, so fuel and wage costs continue to pressure margins.
The unrelenting strength of the US dollar will negatively impact earnings for companies doing business overseas. With approximately 40% of the sales of S&P 500 companies coming from international sources, this negative drag for dollar strength is likely to be a consistent issue for companies selling products outside of the US
Earnings expectations have plunged to -4% year-over-year, which would be the first decline since the third quarter of 2020. With the bar significantly lowered for companies, actual earnings could exceed estimates. Forward guidance from companies will be a focus since the aggressive Federal Reserve rate hikes are leading to expectations of a recession in 2023.