- Revenue growth is picking up in tech and telecoms sectors but slowing in cyclically exposed sectors
- Capital expenditures among the reporting companies increased by 4.1%, particularly in the tech sector
- Consumer spending is under pressure, especially general merchandise, as households shift to services from goods and inflation pressures household budgets
- Banks are guarding against an extended period of elevated losses in commercial real estate and normalization of delinquency rates for consumers, but lending activities have stayed steady overall
- This earnings season appears to be an indicator that the economy is transitioning into a healthy market
The third quarter earnings season is coming to an end. So far, it has been a kind one to investors.
According to Bloomberg data, of the 444 companies within the S&P 500 that have released their quarterly reports so far, 83% of them announced profits that beat Wall Street expectations. That has helped fuel a 4.3% rise in the S&P since companies started releasing their quarterly reports on October 17.
The details of these reports are more mixed. Revenue growth seems to be picking up in the technology and telecom sectors but is slowing in some of the more cyclically exposed sectors.
Consumer-based firms are reporting slowing volume sales, while banks are increasing their reserves for future losses.
What does this tell us about where the economy and market are heading next?
Company profits are rebounding
While inflation and interest rates got all the attention in 2022, there was also something of an “earnings recession” occurring at that time. An earnings recession happens when companies broadly suffer a decline in profits.
A common way of looking at this is to sum up the profits of S&P 500 companies before interest, taxes, and depreciation. This is a close approximation of the cash flow-based profitability of companies.
The chart below shows the percentage change in earnings compared to the same quarter from the previous year. You can see that we had three consecutive quarters of negative earnings growth before this quarter, but earnings have since rebounded by +5.5%.
However, this profit rebound isn’t hitting all companies equally. The chart below shows the same profit growth measure but looks at specific subsets of companies.
The red bars represent consumer companies, the green is technology and telecommunications, and the gray represents the classically cyclical sectors of industrials and materials.
Here, we see that in 2022, tech and telecom earnings floundered while the cyclical sectors held up better. This was a big reason why tech within the S&P 500 was down 28%, and telecom was down 40% in 2022. Meanwhile, industrials were only down 6% and materials down 12%.
In 2023, those roles have reversed, with tech and telecom earnings rebounding rapidly while industrials and materials have fallen off. Meanwhile, consumer firms have also enjoyed substantial growth this year. Hence, it is no surprise that the three best-performing sectors in the S&P 500 for 2023 are tech (+52%), telecom (+52%) and consumer discretionary (+35%), while industrials (+9%) and materials (+6%) have lagged.
Businesses continue to invest in growth
One key metric we watch is capital expenditures. This is the money a company spends on acquiring, producing, or maintaining long-term assets—things like a new building, equipment, or technology.
When firms are confident in their future, they tend to invest in these long-term assets. But when they are nervous, these are likely the first things they cut.
From a macro perspective, this spending category is the most volatile component of GDP and usually drops the most during a recession.
Capital expenditures grew a very healthy 4.1% this quarter among the companies that reported. The tech sector had the biggest increase in capital expenditure spending, up 9% during the quarter. Moreover, it appears the tech sector was also the beneficiary of investment spending by other firms.
Some of this is probably related to the boom in artificial intelligence (AI). As companies expand their use of AI, it triggers a variety of investment spending, from more powerful processors to greater use of cloud computing.
In 2022, growth of cloud spending dropped substantially. This may have something to do with the overall bust in cryptocurrencies and other speculative tech companies. This quarter saw the first acceleration in cloud spending since 2021.
It may be that some of this cloud spend on web servers for speculative tech companies is being replaced by spending by more established companies, in part on AI-related projects. That would fit with strong results from semiconductor companies this quarter as well.
We are often asked how the Facet portfolio invests in AI. In our view, the benefits from AI will likely flow to traditional companies that implement AI solutions to problems. It will also flow to the companies that make products supportive of AI, like cloud computing and semiconductors. It is less clear to us that AI-related startups or application providers will be winners, particularly the collection that is investable today.
Consumer spending under pressure
There were a few key takeaways from some individual company reports. First, consumer spending is under some pressure, especially in “general merchandise.” For large general retailers like Walmart or Target, general merchandise refers to virtually everything that isn’t food or medicine-related.
This past quarter, Target reported a 5% decline in overall sales for stores open for at least a year. While Walmart reported US sales growth of 5% on the same basis, general merchandise sales declined while grocery sales made up the difference.
Both companies cited similar issues for the decline in sales, including the resumption of student loan payments, inflation pressuring household budgets, and consumers shifting to spending more on services and less on goods. Both also discussed the need to keep prices low going forward.
This is notable because it tells us something about inflation. Inflation is fundamentally a product of consumers spending dollars at a faster pace than the economy can produce goods and services. In other words, it is when demand is outstripping supply.
If companies raise prices to the point where consumers can no longer afford to pay them, that’s where inflation ends. In fact, Walmart went so far as to say, “We may be managing through a period of deflation in the months to come.”
The macro data tells us that inflation is subsiding. It is a positive sign to see the microdata from these large retailers confirm what we see in the macro data. It indicates that the disinflation trend is probably here to stay.
Bank credit concerns are ticking up
It has been about eight months since Silicon Valley Bank collapsed, with Credit Suisse and First Republic failing shortly thereafter. At the time, there was reasonable worry that banks generally might choose to lend less as they tried to strengthen their balance sheets.
That has not happened. Of the banks within the S&P 500 that have reported so far, 53% have increased total loans since the first quarter based on data from Bloomberg. It may be true that banks would have extended lending more aggressively had the SVB event never occurred, but overall, bank lending appears to be steady.
However, banks are increasing their loan loss reserves (LLRs). These reserves are really just an accounting entry. The bank estimates the chances of each of its loans going bad and marks down the value of its loan book by this expected loss value. That markdown is the loan loss reserve.
In aggregate, banks raised their loan loss reserves this quarter, with 81% of S&P 500 banks increasing reserves as a percentage of their loans (Bloomberg data). This is a trend that started last year.
Actual loan losses were far below what was feared after the pandemic, enabling banks to rapidly reduce their loan loss reserves in 2021. By the middle of 2022, reserves hit a trough and have been slowly rising ever since.
We can see from the chart above that loss reserves are still well below 2020 but are well above the pre-COVID lows.
What this tells us is that banks, in general, do have concerns about their loan books. We know that commercial real estate has been struggling, especially in the office and retail space. Many banks have heavy exposure to real estate, so this is probably a driver of higher reserves.
Consumer delinquencies have also been on the rise recently, although they are still extremely low by historical standards. According to the New York Fed, 2.99% of consumer loans are in some stage of delinquency. That’s up from 2.5% at the end of 2022 but far lower than the average of 4.94% from 2014-2019.
From listening to the various earnings presentations, banks, in general, are guarding against an extended period of elevated losses in commercial real estate as well as a normalization of delinquency rates for consumers. This isn’t especially worrisome from a macro perspective but could be a source of headwinds for bank profits in the coming quarters.
Overall, a strong foundation
The fact that the earnings recession appears to be over is extremely important. It tells us that the rise in stocks in 2023 is supported by company fundamentals. It also tells us that companies are adjusting to a higher rate environment.
In addition, the fact that the stocks that are outperforming are the ones delivering earnings growth is a positive sign. It tells us that this isn’t about speculation but rather a rational sorting of companies by how their business is performing. That is how a healthy market acts.