“We model sales and margins separately, given the nuanced impact of various macro factors on each variable. But economic growth is the primary driver of EPS growth.
“Our economists forecast real US GDP growth will slow from 1.9 per cent in 2022 to 1.0 per cent in 2023. Our forecast for 0 per cent EPS growth in 2023 is consistent with the historical relationship between real GDP growth and EPS growth. Financials will post the fastest growth and Materials the slowest growth.”
Kostin also said the outlook would further dim if the US enters a recession.
“In a [moderate] recession, we expect S&P 500 EPS would fall by 11 per cent to $US200. Our economists assign a 35 per cent probability of recession in the next 12 months and note that a recession would likely be mild given the lack of major financial imbalances in the economy. However, many equity investors believe a recession will begin at some point during 2023.”
“A deeper or more prolonged recession poses downside risk to our recession scenario EPS. Revisions to bottom-up 2023 EPS estimates have been particularly sharp this year, but we see room for further cuts.”
According to FactSet, analysts expect a decline in earnings of negative 1.0 per cent for fourth quarter 2022 but earnings growth of 5.6 per cent for calendar year 2022. For first quarter 2023 and second quarter 2023, analysts are projecting earnings growth of 2.3 per cent and 1.5 per cent. For calendar year 2023, analysts predict earnings growth of 5.9 per cent.
Tech red flag
In a note this week, Warren Pies at 3Fourteen Research also flags concern about margins. “Going back to the ’90s, the typical recession trims profit margins by somewhere between 200 and 500 basis points. Peak to trough, this process takes about 2 years on average.”
Pies said “if we assume 2023 sales estimates and a simple reversion of margins to pre-COVID levels, then S&P earnings would fall to $US180 per share”.
Conventional wisdom argues that with the days of cheap energy and money behind us, an economy-wide margin compression is at hand, Pies also said, adding that: “Historically, though, the sectors that expanded margins the most in the run-up to the peak suffer the greatest in any subsequent contraction.”
“For the past decade, the tech and communication service sectors are responsible for 100 per cent of the S&P 500’s margin growth. If you are bearish on S&P margins, then you are bearish on tech margins.”
Pies points to what happened in 2000 as reference. “From the 2000 peak to the 2002 trough, S&P margins fell by about 200 basis points. Tech was responsible for 105 per cent of this decline.
“In other words, Tech’s margin collapse accounted for more than all of the S&P 500’s loss (energy, financials and health care grew margins over this time). On the other hand, in the years leading into the 2000 earnings recession, tech was responsible for 70 per cent of the margin expansion (financials contributed the remaining 30 per cent).”
While the narrative floating around is that low rates and cheap energy allowed all companies—across all sectors—to boost margins to levels that will prove unsustainable under the new macro regime, Pies said the sector-level data does not support this conclusion. “Rather, the growth of high-margin tech companies’ weight within the S&P seems to be the proximate cause of today’s double-digit index margins.”
Pies said investors should hold to the sidelines. “We believe CPI will decelerate rapidly in 2023, but substantial improvement is not likely until early 2023. This makes the next few months dangerous for equities. A disappointing fourth quarter would be a catalyst for a breakdown.”