Asset Allocation Strategy
13 May 2024
US Equities: Earnings Foundations Remain Strong
US Earnings Season Delivers Again

While the US equity market has been buffeted recently by shifting expectations for inflation and interest rates, corporate earnings continue to be a positive support. 

The latest US reporting season is nearing completion and has once again painted a constructive picture around the corporate earnings backdrop.

In general, the investor response to strong earnings was muted in a period that saw an increased focus on the outlook for interest rates but the foundations of the US corporate earnings cycle remains encouraging. Overall, 77% of companies have reported actual EPS above estimates, which is slightly above the 10-year average of 74%. In aggregate, companies Q1 earnings that are 7.5% above estimates, which is also above the 10-year average of 6.7%.

Figure 1: US earnings are picking up again (S&P500 actual and consensus estimates)

Near Term Estimates Moderately Upgraded

While positive earnings surprises are expected during US reporting seasons, we believe a stronger signal is coming from revisions to forward estimates with S&P500 forward earnings estimates having been moderately upgraded during reporting season. The Q2 bottom-up EPS estimate has been increased by 0.7%. quarter, analysts usually reduce earnings estimates during reporting season. Indeed, during the past five years (20 quarters), the average decline in the bottom-up EPS estimate during the first month of a quarter has been 1.9%. April 2024 marked the first time the bottom-up EPS estimate increased during the first month of a quarter since Q4 2021.

With solid revenue growth of 4.9% (4.1% in Q1) and continued margin expansion, the consensus is forecasting market earnings growth of 11% in 2024 and 10% in 2025. These estimates have remained relatively stable in recent months despite concerns that they would prove too high. We expect estimates for 2024 to ease moderately as the US economy slows but recent upgrades to 2024 forecasts, while modest, provide a degree of comfort in the earnings outlook.

While results have generally been good, the US technology sector has again been a standout with strong earnings growth delivery and upgrades to forward estimates. The strong performance of the tech sector seen over the past year has undoubtedly been influenced by bullishness towards the structural growth prospects for big cap tech. However, performance is also grounded in the strong earnings growth delivered over the past 12 months, which has been superior to the broader market.

Figure 2: CY2024 and 2025 sector EPS growth estimates (ranked by 2024 growth)

Earnings growth estimates appear more even across sectors going forward which suggests tech leadership may fade, at least for a period. Indeed, sector performance over the last few months has been much more even. While the tech sector may come back to the pack after a stellar run the sector's performance does not appear to be speculative in the sense earnings are coming through strongly. In short, tech outperformance may pause; we don't see the sector as being in a valuation bubble.


Do Recent Signs of an Economic Slowdown Threaten the US Earnings Cycle?

After a prolonged run of upside surprises there have been signs of slowing in the US economy in the economic data released so far in May (payrolls, ISM services).  This cooling trend is still only tentative but  interesting in the context of the market’s April capitulation on the prospect of rate cuts late in 2024. This has been partially reversed in the last week or so, as US economic data has printed softer.

It is too early to say whether a surprise slowdown in the US economy, while positive from an inflation and interest rate perspective, will pose significant risk to the US earnings outlook.

Figure 3: Europe's economic surprise series has improved recently as the US has slipped

US Underpinned by Corporate Earnings Power but US Exceptionalism Takes a Breather

Our base case remains for a soft landing rather than a sharp slowdown/recession. A moderate US economic slowdown combined with the relatively defensive nature of the US earnings base suggests downside risk to the earning outlook is unlikely to be large. Outside of the US economy, “rest of world” growth is actually looking better relative to the start of the year. This combined with a softening US dollar (40% of S&P500 revenues are earned outside the US) should also act to mitigate downside US earnings.

While earnings have been supportive there are still concerns that the market is expensive. The US market’s PE multiple remains elevated versus history and versus the rest of world though we believe the PE rating of the US market while full, is broadly justifiable based on  track record and structural outlook for corporate earnings growth.

Figure 4: Structural growth dominance explains the majority of US market outperformance over the last 10 years
Figure 5: The US market is not cheap but is supported by superior long term earnings growth

A relative softening in the US economy and more imminent rate cuts (the ECB is expected to cut in June) may enhance the case for “rest of world” equities particularly when combined with less demanding valuations. Much like the pattern of more US sector performance, recent regional performance trends have been more even recently. Indeed, “rest of world” developed stocks and EM equities have both outperformed the US over the past 3 months. We believe the rest of world can at least match, or marginally outperform, the US over the next 6 to 12 months as growth rates equalise and policy cycles turn more favorable in rest of world.

Figure 6: Rest of world earnings revisions have improved over the last couple of months as economic growth momentum improves
Figure 7: The "world ex the US" is not expensive and we expect earnings growth will pick up over the next 12 months
Figure 8: The outperformance of the growth style has eased over the last couple of months

Death of the US Market: Wildly Exaggerated

We remain constructive on the US market in an absolute sense over the next 6 to 12 months but its strong outperformance may fade. The path of US inflation over the balance of the year will be important for interest rates and equity market sentiment but earnings continue to stand as a supportive pillar for US equities.

Signs of more even performance are emerging at the sector, style and the regional level after an accentuated period of mega cap tech led US outperformance. We expect these recent shifts to extend, however, the US market’s structural earnings advantage suggests the US remains well placed over the medium to longer term.

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Written by

David Cassidy, Head of Investment Strategy

David is one of Australia’s leading investment strategists.

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