By Wolf von Rotberg, equity strategist at J. Safra Sarasin Sustainable Asset Management
The US earnings season is coming to an end. Despite elevated consensus expectations going into the season, 77% of companies still managed to beat on earnings. Sales beats were at a more moderate 57%, but sales growth at 7% for the S&P 500 was still the strongest since Q4 2022. Those numbers provide little reason to be worried, even though they are once again predominantly driven by the Magnificent 7. The one pocket of the market that has been notably weaker is consumer discretionary. Removing the heavyweights Amazon and Tesla from the consumer discretionary aggregate, the sector recorded the first year-over-year drop in EPS since early 2021. The soft numbers have been accentuated by management communication, which has in many cases flagged a waning of consumer demand, driven by the low end of the income distribution. More specific areas of weakness have been travel, home improvement, auto, durables and fast food, where a noticeable restraint by consumers has been mentioned, weighing on Q2 results.
The US Q2 earnings season is coming to an end. Of the 86% of companies which have reported so far, 77% have beaten pre-season earnings expectations. This is not only above the five-year average of 76%, but it also marks the highest earnings beat rate since Q4 2021. At 12%, year-over-year EPS growth has also registered the highest rate since Q1 2022. Yet despite the strong data, market performance has been soft since the season started in mid-July. The S&P 500 has lost 3.5% since 15 July as positive earnings surprises gained less than usual while negative surprises lost more.
Companies that have surprised positively have seen an average price increase of 0.8% two days before the earnings release through two days after the earnings release. This is below the five-year average price increase of 1.0%. At the same time, companies which have reported negative earnings surprises saw an average price decrease of 3.8% two days before through two days after the earnings release. This is larger than the five-year average price decrease of 2.3%.
The reason for the market’s softness certainly goes beyond reported Q2 earnings and has to do with wider concerns about the US cycle. Yet the underlying data and message from the earnings season was also less positive than the headline numbers are suggesting. We think three observations are worth mentioning in this regard.
Sales have been softer than earnings
While 77% of companies have managed to beat earnings expectations, only 57% of companies reported better than expected sales numbers. The YoY sales growth rate at 7% has also been well short of the EPS growth rate at 12%. Earnings growth has thus come to a large extent from solid net income margins, which have risen back above 12%, on par with the peaks seen over the past two years. Is this a reason to worry? Probably not. Although weaker than earnings growth, sales growth at 7% YoY still marks the highest rate since Q4 2022, indicating that companies were able to raise their margins on the back of solid top-line growth, most likely via continued pricing power and strong cost discipline.
The Magnificent 7 remain the most important growth driver
The Magnificent 7 have once again delivered the majority of EPS growth in the S&P 500. Even though NVIDIA yet has to report its Q2 numbers (28 August), it is clear that the Magnificent 7 have once again contributed to the majority of EPS growth. Removing them from the S&P 500 aggregate, YoY EPS growth for the index drops from 12% to 3.2%, which would still be the highest growth rate since Q4 2022, but markedly lower than the double-digit number if all S&P 500 constituents are included. On a positive note, the broadening of the earnings recovery is definitely visible in Q2 data. On a more negative note, underlying earnings growth still looks very sluggish. This begs the question whether the large valuation premium of US sectors vs other regions is justified, in particular given that other regions are producing similar earnings growth rates outside tech.
The low-income consumer shows signs of cracking
A broad set of companies, ranging from travel & leisure to apparel, retail, home improvement, fast food chains and autos are reporting a fade in demand and an increasingly exhausted consumer, particularly in the lower half of the income distribution. Consumers are starting to cut back their discretionary spending and this is becoming more visible in reported earnings. The consumer discretionary sector is naturally the most exposed to slowing demand. Once the two heavyweights Amazon and Tesla are removed from the sector, consumer discretionary has seen the first decline in reported earnings since the beginning of 2021.
In conclusion, the Q2 earnings season has been strong in terms of beats and earnings growth rates. The most concerning feature, however, is what companies have to say about the low-income US consumer. Some companies may benefit, as the combination of a cooling labour market, easing price pressures and lower funding costs helps margins. Yet if demand were to slow more aggressively, the hit to top-line growth would likely outweigh the positive impact from cost reductions.
