Key Questions: Earnings Growth Is Slowing; What Should Investors Do?
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Rising wages, escalating costs, an inflated dollar and weakened demand all ate away at profit margins but there are a few encouraging signs, too, so smart investors should remain sensible but nimble.
Earnings season for the second quarter of 2022 is nearly complete, with 90% of S&P 500 companies reporting results. Of those companies, 75% have reported better-than-expected earnings, and 70% have reported better-than-expected revenues. However, in the aggregate, earnings growth has declined for the S&P 500 to 6.7%, marking the slowest earnings growth rate reported for the index since the fourth quarter of 2020 (4%). In addition, earnings have beaten estimates by only 3.4%, which is below the five-year average of 8.8%.
Six out of the 11 sectors reported year-over-year (YOY) earnings growth. The top performing sectors were energy, industrials and materials. The energy sector was such a substantial contributor to the earnings growth of the S&P 500 Index, however, that if it were excluded, aggregate earnings would show a YOY decline of 3.7%.
Financials, consumer discretionary and communication services were underperforming sectors, reporting a YOY earnings decrease. As of this writing, the number of S&P 500 companies that have reported a positive earnings surprise will be at the lowest percentage since the first quarter of 2020.
A distinct difference between this earnings cycle and previous cycles is how the market rewarded and penalized positive and negative surprises, respectively. Companies that generated better-than-expected earnings saw their stock price gain over 2%, more than twice that of the 5-year post-earnings gain of 0.8%. Similarly, companies that reported negative earnings surprises saw, on average, a net gain of 0% versus the 5-year average of a 2.4% stock price decline, suggesting that investors were already anticipating disappointing results in some instances.
Why Is Earnings Growth Slowing?
Several factors affect companies’ financial performance, including rising wages, escalating input costs, an inflated US dollar, and weakened demand, all of which eat profit margins. For some companies, the cost of wages cannot be passed on to the consumer; it is up to the company to mitigate those costs by reducing employment or increasing automation. Companies that can pass input costs on to the consumer may benefit in the short term but might see weakened demand later if customers do not accept higher prices. A strong dollar can make imports cheaper but can also reduce domestic demand by foreign buyers. Putting these pieces together explains why earnings growth has slowed recently.
Earnings estimates typically weaken before economic slowdowns. In October 2000 earnings estimates fell ahead of the recession of March 2001. Likewise, in September 2007 earnings fell before the recession in December 2007; and in September 2018, long before the recession in February 2020, earnings also slowed.
However, this is not a perfectly correlative relationship. There have been periods of slowing earnings growth that did not foreshadow a recession. For example, following the 2001 recession, earnings declined by 60%, while the S&P 500 fell only 18.8%. In the wake of the 2008 recession, earnings declined by 40.8%, while the S&P 500 rose 22.6%. Between 2015 and 2016, the S&P 500 rose 6.7%, while earnings declined 17.5%.
Slowing earnings growth for one quarter does not necessarily indicate a trend or a cause for alarm. While there is a precedent for declining earnings before economic slowdowns, it is not always a hard-and-fast rule.
There are also improving signals, such as the inflation metric, the Consumer Price Index, which rose at a slower pace in July, and a new 65-day high with the S&P 500. Both indicate a potential bullish change in market sentiment. In addition, earnings are only one measure of profitability; we use a well-rounded, multifaceted approach to valuing companies.
What should investors do? Investing is a balancing act between managing uncertainty and managing large amounts of information, underscoring the importance of deciphering “news versus noise” – or determining what is truly meaningful information.
As such, investors should remain focused on the big picture and their financial objectives. Tilting your portfolio toward high-quality assets properly balanced with low- volatility strategies with low correlations to the market is a sensible strategy while remaining nimble but not overreacting to one signal among many.
For more information, please contact your advisor.
About Sara Sugi
Sara Sugi is a Research Analyst on the Equity & Fixed Income Research team in the KeyBank Investment Center. She holds a Master of Science in Finance from Queen Mary University of London and a Bachelor of Business Administration with a concentration in Finance from the University of Northern Colorado. She is a CFA Level 1 candidate and a member of CFA Society Cleveland. Within the Equity Research team, she is responsible for coverage of Utilities. Her Fixed Income Research responsibilities include surveillance of all municipal fixed income investments at KeyBank Investment Center. Prior to joining Key, Sara had various opportunities to perform financial research and analysis, most notably as a member of the team that won the 2019 CFA Institute UK Research Challenge. Sara also spent time with the University of Northern Colorado's Student and Foundation Fund, an entirely student-run, long- term equity fund supporting over $2.5 million of the University’s endowment.