Thought of the day

The first full week of the fourth quarter earnings season has ended and the results have been underwhelming—as we expected—rather than alarming. While it is still early days—only 13% of the S&P 500 by market capitalization has so far reported, with half of this being from financials—62% of companies have topped earnings forecasts. That compares to 74% on average since the final quarter of 2015.

Results from large banks suggests that consumers are still in good shape, unsurprising given that the unemployment rate matched a 50-year low of 3.5% in December. Consumer-oriented companies, especially those that are leveraged to services such as travel, have also echoed the resilient consumer spending theme.

But, although the early stages of the season are not raising any red flags, the outcome so far underscores our view that the broad US market continues to face headwinds and that investors will benefit more from a selective approach.

The earnings outlook for 2023 remains lackluster. While companies have not been sharply lowering their earnings outlook, as some investors feared, we have seen further reductions in expectations. For those companies that have reported, the median earnings per share estimate is 1.8% and 1.1% lower for the first quarter and 2023, respectively. Since the start of the year, the bottom-up consensus estimate for 2023 S&P 500 earnings per share has drifted down from USD 229.5 to USD 226.5. We expect further downward revisions toward our 2023 S&P 500 EPS estimate of USD 215.

As we highlighted in our earnings preview note, we expect no earnings growth this quarter—the slowest pace in two years—with revenue expansion of 4–5%. This represents a sharp slowdown in revenue growth that should lead to a continued normalization in profit margins from higher-than-average levels in 2021.

A slowing US economy looks likely to maintain pressure on companies. Although the strength of the labor market should help the US economy avoid a recession, in our view, the economic backdrop is set to be challenging as the delayed effect of Federal Reserve rate hikes filter through. The savings rate has fallen close to 2%, near its record low, suggesting limited capacity among consumers to continue to spend. The housing sector has turned sharply lower in response to higher mortgage rates: Existing home sales are down 35% year-over-year in November. Leading indicators also suggest weakness ahead: The ISM manufacturing PMI has been in contraction territory since November, and the ISM services PMI fell to 49.6 in December, the lowest reading since May 2020.

Given this trajectory, valuations are not yet attractive in the near term for the US market. The MSCI US index is trading on a forward price-to-earnings ratio of 17.7x, a 10% premium to its 15-year average. That is greater than the 5% valuation premium for global stocks overall and the 4% premium for the MSCI Emerging Market index. We also see areas of the market where valuations are less demanding in the near term, with consumer staples trading in line with the 10-year average forward ratio of 19.3x, based on MSCI data. The energy sector is trading at a 45% discount to its 10-year average P/E.

So, in our view, the risk-reward trade-off remains unfavorable for broad US indexes, and we retain a Least Preferred stance on US equities and the technology sector. We don't see much scope for markets to rally in the near term, especially given our outlook for continued pressure on corporate profit growth. Our June and December S&P 500 price targets are 3,700 and 4,000, respectively, versus 3,972 at the end of last week.

Instead, we think selectivity will be rewarded, and our positioning reflects that. We incorporate a combination of defensive, value, and income opportunities that should outperform in a high-inflation, slowing-growth environment, alongside select cyclicals that should perform well as and when markets start to anticipate the inflections.