Setting the stage - A look back at 2024

By all accounts 2024 was a strong year for US equity markets with the S&P 500 ending up 23%, its second consecutive annual gain of >20%. The last time this happened was in the 1990’s and only the fourth time in history. Interestingly a topic that has been debated throughout last year was the similarity in the current environment to that time period with the technological revolution and a mid-cycle adjustment by the Federal Reserve the common threads.

During the year the US economy continued to outperform expectations driven by a mix of resilient consumer spending, AI related capital investment and growing fiscal deficits. Hiring cooled throughout the year but separations remain low. The unemployment rate moved up to 4.1% from 3.7% at the start of the year, but also remains low by historic standards. After a scare in Q1 inflation continued to moderate in 2024, though the last mile is proving to be difficult. The cumulative impact of higher inflation over the last couple of years and affordability in the US housing market is creating a bifurcation within income brackets as lower income consumers bear the brunt of the pain.

After holding policy rates steady for a little more than a year the Federal Reserve began its much-anticipated policy shift by cutting 50bps in September followed by two additional 25bps cuts in November and December. However, at the last meeting Chair Powell signaled that the pace of cuts going forward would slow as the economy continues to outperform expectations, inflation remains sticky and given the uncertainty related to the impact of Washington policy with the incoming administration.

By historic standards it was a year of reasonably muted volatility. Until the summer the S&P 500 had its longest streak without 2% decline since the start of the Great Financial Crisis back in 2007 lasting 356 trading sessions. The VIX hovered in the mid to low teens for much of the year though there were a couple of bouts of volatility including the one in August. That in part was caused by a growth scare following a weak jobs report but as we highlighted at the time it seemed to be more of an unwind of crowded positioning around the globe including the Yen carry trade triggering a bout of systematic de-risking. This led to the max drawn for the year which on a closing basis was 8.5% (just under 10% on an intraday peak-to-trough), slightly less than the median annual decline since the mid-1980s.

The election was expected to be a volatility inducing event and investors were looking for some pre-election weakness which never really came to fruition. The decisive victory by President-elect Trump led to a broad-based rally in US markets during the month of November. However, some of that optimism unwound in December as interest rates rose despite Fed cuts and a messy stop gap funding bill negotiation reminded investors of the slim margins in Congress, which will make it difficult to push forward the Trump agenda heading into 2025.

Coming into the year there was an expansion of breadth with the Fed pivot at the end of 2023. However, it was another choppy year for small/mid-cap stocks and cyclical sectors. There were a couple of bouts of outperformance including post-election, but the December selloff wiped out pretty much all of those gains. These indices were both up >10% for the year but underperformed the benchmark S&P 500 by ~10% for the second consecutive year.

Inside the Numbers - Data compliments of FactSet Earnings Insight as of January 10, 2025

Q3 Review

Q4 EPS Est. +11.7% YoY

Q4 Revenues Est. 4.7% YoY

Capital return programs - Data compliments of S&P Global

The Big Picture

Overall, Q3 earnings were pretty strong up 7.5% YoY. The average company beat estimates by 4.6%, though the percentage of companies which came in ahead of estimates was slightly below historical averages. Revenue growth ticked back above 5% with healthcare providing the biggest upside surprise while AI demand continued to drive double digit growth for info tech. Despite the solid results it felt like earnings took a back seat to the evolving macro backdrop and the election. Many of the same themes were prevalent with companies continuing to highlight efficiency measures which were helping the bottom line. Management teams continued to call out some global demand weakness particularly in China. AI related spending remained very strong though some suppliers faced some operational and margin challenges. The US consumer also remained resilient but has become increasingly more cost conscious.

Heading into the reporting season there has been an above average number and percentage of companies issuing negative guidance. This helped to drive a negative EPS revision of 2.7% since the end of Q3. However, that decline is below historical average of ~3.2% over the last 5/10/15yrs. According to FactSet analyst estimates are calling for 11.7% YoY EPS growth. This quarter I’d expect many of the themes to be very similar to what I discussed above, however there are some new challenges.

During Q4 domestic economic activity was strong with some signs of re-acceleration post-election but activity around the globe remained much more sluggish. Revenue growth has been moderating for the last two years but seems to be settling in between 4.5% - 5% or about ~2.5% real growth when compared to average PCE during Q4.

There are some signs that the destocking cycle which has been in place over the last couple of years may be coming to an end but some of the pickup in demand is likely a pull forward ahead of potential tariffs. Morgan Stanley highlights that the spread between ISM New Orders & Production has historically been a good predictor of this turn which ultimately leads to positive EPS revisions.

Previous efforts to cut costs and improve efficiency should continue to support the bottom line and margins. This quarter gross margins are expected to tick down to 12.0% from 12.2% in Q2. Management teams have acknowledged that it is harder to pass on price increases to customers as the prolonged impact of inflation has taken its toll. This dynamic will make it more difficult to pass on costs associated with tariffs.

Other potential headwinds to margins:

A concern for multinational companies, is the rally in the USD which is up nearly 10% since the end of Q3. Within the S&P 500 info tech, communication services and materials all have ~50% of their revenue coming from international markets. How this and the implementation of protectionist policies are impacting demand will be a hot topic. According to BofA this increase could be a 3% drag on S&P 500 earnings.

Over the same time period 10yr Treasury yields are up nearly 100bps despite the Federal Reserve cutting rates which is not typical (see Chart).

Companies have done a good job of terming out their debt, but this can start to impact capital allocation decisions, loan growth and overall demand.

The higher cost of capital, rising stock prices and investment in the business have impacted capital return programs. Total shareholder returns were down 1.5% on a QoQ basis driven by a 4% decline in buybacks. The biggest declines were in healthcare, consumer staples and info tech. The latter was down 6.4% QoQ but still made up ~28% of all buybacks for the quarter. Companies are getting less EPS bang for the buck as stock prices have moved higher and some management teams have become more price sensitive. However, dividends hit a new record up 2.4% QoQ.

Financials will dominate the early part of earnings season and expectations are higher than they have been recently given the hope for an improved regulatory environment, an increase in capital markets activity and the steepening of the yield curve. Commentary around those topics and the macro environment will be closely watched given their unique vantage point.

Credit quality is one of the more anticipated aspects of bank earnings. There has been an increase in delinquency rates but much of that is happening within the lower income borrowers. Thus far there have not been signs of that spreading. Loan growth is expected to remain tepid with the recent backup in yields further pushing out a turn in demand.

AI will obviously continue to be a big topic of conversation with capex spending remaining top of mind. However, I think the AI trade and conversation will evolve this year as investors will be listening much more closely for signs that companies are implementing the technology. Morgan Stanley’s Quantitative Research team used a large language model to comb S&P 500 earnings call transcripts to see the number of companies that are providing a quantification of AI on their business. As you can see the number of companies providing that guidance has increased significantly in recent quarters and as that continues, I think those companies will be rewarded, though it is probably to early to drive a significant shift in the earnings trajectory.

The most important part of earnings season is guidance and that is particularly true at the start of the year as management teams start to offer a more clear view of the year ahead. However, this year that may prove to be more difficult given the uncertainty related to Washington policy under the new administration. Expectations for an acceleration of EPS growth are very high with analysts looking for double digit earnings growth in 2025 across the S&P 400, 500 and 600.

Given the backdrop I think management teams will be conservative. That conservatism may come as a disappointment bringing back memories of last year. At the start of 2024 there were expectations for a broad-based earnings recovery however, as we enter Q4 earnings season the only index that is expected to post growth anywhere close to that initial estimate is the tech heavy S&P 500. This is the year where the earnings gap between the Mag 7 and the rest of the index is expected to narrow (see Chart from J.P. Morgan Asset Management below). Once again, we are starting the year with steeper cuts to estimates for the S&P 400 and 600 indices.