Q2 Earnings Preview: A continued contraction

Analysts are bracing for a potentially grim Q2 earnings season, with companies preparing to report their performance for the April quarter later this week. According to FactSet, market experts predict that earnings will see a decline of 7.2% year-over-year, which is even worse than the expected 4-7% decline forecasted on March 31.
The current market conditions have set the stage for another challenging quarter, with Q2 exhibiting notable similarities to the previous quarter's economic backdrop. To compound these issues, full-year 2023 earnings growth is currently forecasted at just 1.0%, the lowest since 2015.

The latest data from the S&P 500 Earnings Scorecard, published on July 7th, shows that Q2 blended earnings, combining estimates and actuals, are forecasted to reach $436.9 billion. Market experts predict a year-over-year decline of 6.4% and a quarterly decline of 0.9%. Meanwhile, revenue is forecasted to reach $3,661.9 billion, with a year-over-year decrease of 0.8% and a quarterly increase of 0.6%. This marks the first time both earnings and revenue have experienced y/y growth declines in the same quarter since 2020 Q3.

Despite an upbeat Q1, market analysts have downgraded Q2 estimates, setting the bar lower heading into the earning season. However, this downgrade occurred at a slower pace compared to the prior three quarters, suggesting that there may be some potential for positive surprises during the Q2 earnings season.

Market analysts have been revising their Q2 EPS estimates downward over the last three months, with the estimate declining from $54.24 to $52.81 per share. This trend has resulted in a 2.5 ppt downgrade in y/y growth expectations heading into earnings season. However, it is worth noting that the pace of these revisions has slowed compared to the prior three quarters, where estimates were revised downwards by an average of 6.8 ppt.

The energy sector is currently acting as a significant drag on the index growth rate, which is an unusual occurrence. The last time this dynamic was observed was during the 2020 pandemic, when oil prices plummeted. This trend underscores the significant challenges facing the energy industry and highlights how global events can have far-reaching impacts on broader financial markets.
Moreover, ex-energy earnings growth, which excludes the energy sector from the equation, is forecasted to be negative for the fifth consecutive quarter. This figure surpasses the three-quarters of negative ex-energy growth seen in 2020, underscoring the ongoing headwinds faced by companies in other sectors aside from energy.

The industrials sector is predicted to continue its streak of ten consecutive quarters of positive y/y earnings growth, while the energy sector's nine consecutive quarters of growth are expected to come to an end.

Communication services and utilities are expected to post positive y/y earnings growth this quarter after several quarters of negative growth.

However, information technology and basic materials sectors are forecasted to see their fourth consecutive quarter of negative earnings growth, followed by real estate and healthcare at three consecutive quarters.

From an earnings growth contribution perspective, six sectors are expected to have a positive earnings contribution, while five sectors will have a negative contribution.

Consumer Discretionary is expected to make the largest positive contribution of any sector, contributing 1.6 percentage points (ppt) towards the index growth rate of -6.4%. Financials (0.9 ppt) and Communication Services (0.7 ppt) are the next largest contributors, while Energy (-5.7 ppt), Healthcare (-2.7 ppt), and Materials (-1.2 ppt) are set to be the largest detractors from earnings growth this quarter. These trends highlight the importance of carefully evaluating sector performance and broader economic indicators before making investment decisions related to the current financial landscape.

As investors gear up for the Q2 earnings season, there are two major criticisms of the current market. Firstly, valuations are relatively stretched despite tepid earnings and rising interest rates. Secondly, the narrowness of the rally is a concern, with the S&P 493 practically flat when stripping out the top seven stocks in the market.

Market analysts are forecasting a potential recovery in earnings growth, according to IG Bank. The commentary from corporates will be essential to evaluate whether these expectations are shared.While macroeconomic forecasters and even the US Federal Reserve predict a technical recession is likely in the US in the short term, forward earnings indicate that an actual economic contraction can be avoided.

Despite earnings growth slowing down, profit margins have remained relatively elevated as companies pass on increased costs to consumers.However, FactSet data suggests that margins may have eroded in Q2, despite lower input costs, due to cooling demand in several areas of the economy. Ongoing strength in margins will support resilient profits, but it could also lead to debate over more aggressive tightening from policymakers if it signals stubborn price pressures.

The ongoing rally in US equities has been largely driven by a narrow group of large technology companies that could reap significant benefits from the projected growth in artificial intelligence. Although the information technology sector does not comprise many of these companies, the forward price-to-earnings ratio for tech stocks is currently at a premium to long-term averages.

Investors will be closely monitoring companies to determine how they are integrating AI into their businesses and measuring its impact on profitability.