Weekly Investment Commentary: A valuable earnings season kicks off
Bottom line up top:
- Can earnings manufacture more upside for U.S. equities? In the wake of a strong global equity market rally in the final two months of 2023, the fourth quarter earnings season for S&P 500 Index companies may be telling as to whether the next move for U.S. stocks is a leg up or a leg down. Although the reporting season is just beginning, an earnings contraction is possible after the prior quarter’s upbeat results (the first period of positive growth since the third quarter of 2022). According to FactSet as of 19 Jan, blended earnings growth (a combination of reported and estimated earnings) for the fourth quarter is expected to be modestly negative (-1.7%). That said, it’s too early to draw any sweeping conclusions with just 10% of index companies reporting — a small sample size representing a narrow band of sectors.
On a full-year basis, FactSet’s 2024 consensus earnings growth estimates seem ambitious at +12.2% amid what we see as several downside risks, including elevated labor costs, diminished pricing power due to disinflation, increasing cracks in consumer resilience and a prolonged period of higher interest rates. And with U.S. economic activity expected to decelerate, cost cutting may be the primary tool companies use to protect or expand margins in 2024.
Among the economic signals flashing yellow (or red) are the increasing use and cost of credit accompanied by rising default rates. In addition, though it hasn’t made big headlines, U.S. manufacturing activity is stuck in one of its worst recessions in recent history (Figure 1):
- The Institute For Supply Management (ISM) manufacturing gauge has lingered in contractionary territory (readings below 50) since November 2022.
- The New York Federal Reserve’s Empire State Manufacturing Survey (ESMS) Index has been negative in 12 of the past 18 months. Its precipitous month-over-month drop in December was the second-largest decline in ESMS history.
“While these forecasts for both corporate earnings and the economy’s manufacturing sector may be partly or mostly cloudy, they offer clarity in their implications for investor portfolios, especially within equity allocations.”
Following last quarter’s strong equity market rally, most sectors are now trading at a valuation premium relative to history. The S&P 500 Index ended the quarter with a forward price-to-earnings (P/E) ratio of 19.7x — a 20% premium compared to its average since 2010 (Figure 2). The kickoff of earnings season puts these elevated valuations under the microscope.
Among sectors, health care has defensive attributes that we find attractive in the current economic backdrop. But fundamental stock selection is key: If 2024 plays out like most election years, we expect heightened volatility, and within health care, pharmaceuticals are particularly more vulnerable to negative returns. We therefore favor managed care and health care distributors.
- Managed care has seen a sharp rise in investment income as a percentage of earnings per share (EPS), as the large reserve balances these companies tend to maintain grew appreciably thanks to rising interest rates. We think that the market’s expectations for U.S. Federal Reserve rate cuts this year are overly optimistic, and that a prolonged pause is more likely, thus managed care looks well-positioned for this environment.
- Distributors are a critical part of the health care supply chain, serving as a conduit between manufacturers of medical supplies and the health care providers who use them. Less tied to interest rates than managed care, distributors are defensive and typically fare well when investors rotate into defensive positioning. Additionally, unlike pharmaceuticals, distributors are less sensitive to patent “cliffs” and specific headline risks that may trigger idiosyncratic volatility. Instead, they benefit from generic drug launches.
Information technology has continued to garner headlines and investor attention. While it enjoyed a banner year in 2023, results were dominated by outsized gains from a narrow group of mega cap companies. We generally prefer tech areas that are less cyclical and less consumer-centric, such as software. Software companies often have resilient business models and inelastic demand for their products and services, with cash flows driven by enterprise clients — a more consistent source of recurring revenue than consumers. Lastly, software companies tend to be more adaptable to changes in the economic environment, with the ability to cut costs without curtailing their business.
“The health care sector has defensive attributes that we find attractive in the current economic backdrop.”
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