Top takeaways

What will investors be listening for on Conference Calls?

Broad Economy

Inflation/Margins

Supply Chain

Labor

Capital Allocation

Financials

AI

Setting the stage - A look back at Q2

Q1 ended on a high note with US equity markets extending the rally that started in the final months of 2023. For the quarter the S&P 500 was up slightly more than 10% and was up ~25% from the late October lows, without a 2.5% pullback over that timeframe. Tech led to the upside but there was broad participation as markets were still holding on to hopes for Fed rate cuts despite a couple of months of hot inflation data.

However, Q2 got off to a rocky start following a very strong jobs report and the third consecutive hot CPI reading. During the first quarter equity markets were able to shrug off the move higher in Treasury yields but as 2yr yields approached the 5% level (+~75bps YTD) that took the wind out of the sails. Oil prices were also moving higher as geopolitical tensions in both Ukraine and the Middle East were escalating adding to the inflationary concerns.

Interestingly, the low during Q2 was hit on the day of the retaliatory Israeli airstrikes on Iran, as this was viewed as a de-escalation given the carefully calibrated targets. The selloff lasted all of three weeks, with the S&P 500 falling a little more than 5% over that timeframe, culminating on the day of options expiration, a dynamic we’ve highlighted at multiple major market turning points over the last few years.

The following week was when the Q1 earnings season kicked into full gear and a solid set of results helped to stabilize markets and continued to push analyst earnings estimates higher, a trend that has been an important driver of equities this year.

Shortly thereafter Treasury yields came off the boil. This came in waves starting with the Treasury quarterly refunding announcement which did not increase the supply of bond auctions. Then there was a dovish May Fed rate decision as Chair Powell pushed back against the prospect of further rate hikes and announced a larger than expected tapering of QT. Throughout the remainder of the quarter the economic data also began to move in the Fed’s favor pointing to a moderation in economic activity, labor market dynamics moving back into balance and the resumption of the disinflationary process. This caused Treasury yields to reverse all of that April move higher and about half of the aforementioned YTD move.

The S&P 500 never looked back closing higher in 8 of the final 10 weeks of the quarter. However, there was a shift starting in the back half of May where breadth within the market began to narrow significantly. First, cyclical sectors and small/mid-cap stocks began to underperform as yields started to move higher again. However, the reaction function when yields began to decline also shifted as concerns of an economic slowdown began to seep into the market.

At the same time the AI optimism ramped up a notch following another strong quarter from Nvidia and a 10:1 stock split which led to an unprecedented gain of $1T in market capitalization in just 23 trading days. In addition, there were a steady stream of other AI related corporate events, partnership announcements and earnings continuing to feed the AI hype. The money flowing into this trade seemed to weigh on other areas of the market.

The S&P 500 cleared its Q1 high on May 15th following slightly better than expected CPI reading and the first of what would be a string of disappointing retail sales reports. The index has continued to make new all-time highs since. However, the equal-weight version topped out around the same day and has yet to make a new high underperforming the market-capitalization version of the index by ~7% during the quarter (~10% YTD thru Q2).

The big picture

At a high level the setup coming into this quarter is similar to Q1. For much of last year large negative revisions during the quarter lowered the bar for companies to clear. However, for the second consecutive quarter there were only small negative earnings revisions since the end of Q1 with estimates cut by only ~0.5%, well below the typical quarter where revisions are usually ~-3.5%. Expectations are higher with analysts looking for the largest YoY earnings growth since Q1 of 2022 up nearly 9%. However, like the market performance there is bifurcation beneath the surface.

As you can see below throughout this year the sectors that have the highest YoY earnings growth rates along with positive revisions have outperformed while sectors that saw negative revisions have underperformed. As mentioned earlier that has particularly been the case during Q2 (red line). This sets up a very interesting dynamic in that there are disparate expectations across sectors. The mega-cap tech names are at one extreme as earnings have repeatedly come in ahead of expectations for much of the last year. While the numbers will undoubtedly continue to be strong the street is catching up. The margin of the surprise and absolute growth rates will begin to moderate not to mention that many of the stocks have gone parabolic since the start of the month (until today).

On the other side of things there have been multiple other areas of the market where we have seen negative pre-announcements/earnings revisions including industrials, steel, chemicals, energy and a host of consumer facing companies. As we highlighted above the equal-weight version of the S&P 500 and pretty much every sector in the index ex the tech-heavy triumvirate (info tech, consumer discretionary and communication services) are flat to lower over the last two months. So, I’d argue the bar may be sufficiently low for the rest of the market.

Top line growth been moderating over the last two years. This will be the 15th consecutive quarter of YoY revenue growth, but it is expected to hit its lowest level since June of 2021 at ~4.5% which is only ~2% real growth when compared to average PCE during Q2. In recent quarters there has been a big focus on cost cutting and operational efficiency improvements. This should continue to support the bottom line as the benefits of these actions pay dividends. Gross margins are expected to increase to 12% after bouncing back last quarter (related to financials and FDIC special assessments in Q4 as discussed in last quarter’s preview).

There will be some challenges to maintaining those margins going forward. Management teams have acknowledged that it has gotten harder to pass on price increases to customers as the prolonged impact of inflation has taken its toll. Anecdotally there have been multiple companies particularly within retail that have said they will be cutting prices to try and drive traffic. The gap between input prices and output prices continues to widen.

Improved supply chains and falling logistics were a tailwind over the last year but those costs have also been increasing. The situation in the Red Sea has had an impact pushing shipping rates higher (Chart 1) and companies have been seeking alternative routes adding to shipping times and cost. While trucking freight markets are still struggling pricing has stabilized significantly since bottoming out about a year ago.

The higher cost of capital has impacted capital return programs. Total shareholder returns in the 12 months ending March 2024 were down ~5%. During Q1 buybacks increased 8.1% from the previous quarter, driven by an increase financials and healthcare which offset declines in consumer discretionary. Info tech continues to account for nearly 25% of all buybacks but over the last twelve months expenditures have declined by 11.4% as cash flow is used to fund other capital expenditures primarily AI infrastructure. Dividends declined slightly from record levels in the previous quarter.

Financials will dominate the early part of earnings season and given their unique vantage point of the economy commentary will be closely watched. Credit quality is one of the more anticipated aspects of bank earnings. In that regard, consumer credit delinquency rates have been picking up with much of that happening within the lower income borrowers. Outside of consumer credit quality, CRE and C&I will also be focal points particularly for the regional banks. Loan growth outside of credit cards is expected to remain tepid. Despite a lot of volatility during the quarter rates ended up lower which should help unrealized losses on balance sheets.

A bright spot for financials will be capital market activity. Corporate bond issuance during the second quarter pulled back from Q1 but remained strong which suggests companies continued to extend out maturity profiles. M&A and IPO activity have both picked up momentum albeit from low levels, but investors will be look for confirmation that this pipeline is continuing to build. After the recent stress test results, expectations for additional buyback announcements are high.

Despite the uncertainty analyst estimates are calling for earnings to continue to inflect higher from here. Even calls for a soft landing suggest there will be a slowdown in economic activity with US GDP estimates of 2.4% for 2024 and 1.8% next year. It feels like a lot will need to go right to hit the S&P 500 EPS estimates of ~11% this year and ~15% next year.

Earlier we highlighted that there have been positive earnings revisions since the start of the year, that has started to level off recently. The positive revisions have not been able to keep pace with the >15% gains for the S&P 500 leading to multiple expansion. At this point the S&P 500 is trading ~21X next year’s EPS estimate, which is above historical averages. However, as you can see in the second graphic below from JPMorgan, much of that multiple expansion is happening in the mega-cap tech names. The P/E for the top 10 largest stocks in the index is ~30X but the rest of the index is only trading ~17.6X which is not wildly expensive by any means, especially if that double digit earnings growth comes to fruition.

When it comes to earnings season forward guidance always trumps the quarterly numbers. Given the recent moderation of economic activity, geopolitical risks and uncertainty related to elections I would expect management teams to take a conservative approach. However, investors will be paying even closer attention to conference calls to see if companies are starting to see signs of an inflection point. Despite index volatility remaining depressed, I think we are set up for larger than normal moves in response to earnings announcements similar to what we saw during Q1, particularly to the downside.

Since the start of the year market expectations for rate cuts have recalibrated significantly lower. Throughout that time, we have made the case that markets will tolerate a higher interest rate environment so long as that is being accompanied by economic growth and resilient earnings. That has played out so far. Over the last five years amidst very difficult operating environments, I have been repeatedly impressed by the adaptability of corporate management teams. This gives me comfort that if we are in fact heading into an economic storm that the future is bright on the other side.