Cross Asset Strategy
This week equities and bonds traded sideways as the U.S. earnings season kicked off. After the initial excitement following positive big bank earnings, the market calmed down in anticipation of further results. On rates, we saw Fed officials reiterate a hawkish tone, with Atlanta Fed President Raphael Bostic projecting one more hike followed by a pause, while St. Louis President Jim Bullard favors two. Market expectations stayed stable on the remarks, with a likely 25bps hike in May believed to be the final one of this cycle – and is almost fully priced in. Concerns on commercial real estate (CRE) remain an overhang, as Brookfield Corp announced a default on a $161 million mortgage for a dozen office buildings as occupancy rates plummet. This echoed our concerns over the office sector (we analyzed the issue in detail in a note earlier this month), however we’d note that the office sector is a small proportion of the overall economy and fundamentals in other CRE sectors still remain solid.
Outside of the U.S., China’s March data dump was in focus. Q1 GDP came in surprising to the upside at 4.5% (vs consensus 4.0%). Details in the March activity report suggest strength in domestic consumption and exports, while industrial production, housing and capex were mixed. Our main takes are 1) the normalization after the Zero Covid approach has happened faster than we expected, but this means a flatter slope in 2H; 2) consumption recovery still has some further room to run; and 3) the overall pace of economic growth will likely be moderate, considering the headwinds from housing sector de-leveraging (ongoing) and the global slowdown (yet to happen). Our full-year GDP outlook stays unchanged, and our view on Chinese equities remains constructive.
Strategy Question: Should we chase the U.S. equity rally?
After a start to 2023 that has surprised many given the 8% rise in the S&P 500, first quarter earnings season is a timely pulse check on the current business conditions that U.S. corporates face. Overall, 1Q23 earnings growth is expected to further deteriorate and decline 7.3% YoY (vs -5% in 4Q22) and even the median stock is expected to see earnings fall by 2.5% YoY (vs +2.5% in 4Q22). This compares to a long-term average earnings growth rate of 6.5% for the S&P 500. Margins are also expected to further contract and re-set lower.
Only five out of eleven sectors are expected to grow earnings in 1Q23: these are Consumer Discretionary, Energy, Industrials, Financials, and Real Estate. Consumer and Financials benefit from easy prior year comparables, while Energy companies are shielded from lower oil and gas prices due to hedges that are expected to roll off over the coming six months. Industrials continue to benefit from strong backlogs and infrastructure/re-shoring investments that remain early in the growth cycle in the U.S.
While numerically this is likely to be a weak earnings quarter, market expectations and positioning reflect this pessimism and likely limit negative share price movements following results announcements. We expect management teams to also provide conservative commentary factoring in rising recession risks, expectations of tighter financial conditions, and tight labor markets. Broadly, three themes we are focused on include: a) Bank balance sheets and outlook: including deposit flows, net interest income trends, credit costs, b) Consumer demand, and c) inventories and new orders for consumer and industrial firms.
CONSENSUS EXPECTS 1Q23 EARNINGS TO BE THE TROUGH
S&P 500 YoY % EPS GROWTH
NET PROFIT MARGINS ARE EXPECTED TO COME IN ROUGHLY IN LINE WITH LAST QUARTER
S&P 500 NET PROFIT MARGIN, %
On a more positive note, earnings estimates for 2023 have meaningfully reset since October 2022 and sit just 4-5% higher than our estimates. We also acknowledge that the pace of downward earnings revisions has been slowing in recent weeks, albeit recognizing that 2024 earnings estimates have further room to reset lower. Recent commentary from firms at conferences have also highlighted that end-market demand, costs, and supply chains have been better than expected. The challenge for investors is to simultaneously determine the length and depth of the growth slowdown as well as the start of the next cycle. Could 1Q23 mark the earnings trough? This is likely too early to call. For the overall market, we are of the view that the S&P 500 continues to trade in a tight range between 3,800-4,200 and our 2023 year-end outlook of 4,200-4,300 remains unchanged, offering only modest upside from current levels.
OUR EPS ESTIMATES ARE BELOW THE STREET FOR 2023, AND WELL BELOW THE STREET FOR 2024
S&P 500 2023 EPS OUTLOOK FOR 2023 (LEFT) and 2024 (RIGHT)
What to do?
We continue to believe that the Healthcare sector offers the potential for an attractive risk/reward after the 1Q underperformance, and expect this to reverse in the near term. Another sector we are playing close attention to is the Consumer Discretionary sector, which has been in recessionary conditions for ~12 months. Any inflection in inventory levels and margins could offer meaningful upside. While we remain positive on the semiconductor space, we lean more towards accumulating on dips after the strong 1Q performance. There are also a number of dislocated stocks across a number of sectors that can potentially offer an attractive upside. Please contact your J.P. Morgan representative for a complete list of opportunities as we head into the U.S. earnings season.
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