Third-Quarter Earnings Preview

Highlighting the markets unease, stocks moved 4% on average one day after the second-quarter earnings release. Over two-thirds beat revenue estimates, while more than three-quarters beat non-GAAP earnings estimates, as detailed in the table below. Aggregate revenues of S&P 500 companies grew 14% YoY, while aggregate non-GAAP earnings dropped 10%. Earnings were negatively impacted by the financials sector, as banks built-up large loan loss provisions, but offset by the energy sector's profit windfall. Excluding these two, earnings were flat YoY despite 10% topline growth. Inflationary pressures remained throughout the quarter resulting in a 9% rise in the cost of goods sold (COGS).

Third-Quarter Outlook

For the upcoming earnings season, headwinds are inflation eating into corporate profit margins and a strong dollar adversely affecting U.S. companies with significant international sales. Economic growth will be mildly positive because consumer spending continued to grow, and the trade balance improved, although investments pulled back. Consumer spending (2% QoQ/9% YoY), particularly on services, rose as those priced out of peak summer travel took advantage of declining prices in the last days of summer and early fall. Back-to-school shopping provided another boost to spending. Despite the strong dollar, the trade balance improved due to higher energy exports and slowing consumer goods imports. Investment, particularly in housing, declined as a consequence of rising interest rates.

Financials?sector revenue will be impacted by stagnant investment banking activity and a slowdown in lending (3% QoQ/11% YoY). Auto loans especially stalled as higher interest rates weighed down demand. Earnings will be hit because of additional loan loss provisions, and a declining net interest margin (NIM); the spread between the 10-year and 2-year Treasuries has fallen from +0.5 to –0.3 throughout the year.

Healthcare?sector revenue will rise as health service providers benefit from the demand shift from COVID treatment to elective procedures, which have higher margins. Medical equipment manufacturers also benefit from growing procedure volumes. Weighing on earnings is continued supply chain issues, elevated labor costs (1% QoQ/6% YoY), and the fact that medical prices (2% QoQ/5 % YoY) have not risen as quickly as other parts of the economy.

Materials?sector will see modest revenue growth driven by still elevated commodities prices as consumer spending and manufacturing activity were solid. The Chemicals subindustry is supported by robust prices and stable production. While Construction Materials and Metals & Mining companies also gain from higher materials prices, it is offset by demand deacceleration (1% QoQ/10% YoY).?

Industrials?sector revenue will be affected by lower freight volume (1% QoQ/-3% YoY) across air, rail, truck, and ship, in response to fallen goods demand and muted global trade. Airline subindustry revenues will climb because of strong travel trends through the summer (-4% QoQ/18% YoY), although constrained by canceled flights and limited capacity. Earnings will be negatively influenced by elevated labor costs, with ongoing labor talks for port and rail workers closely watched.

Technology?sector revenue will slow on account of the economic environment. Higher interest rates will hit capital-intensive industries, like hyper-scale data centers, which are a significant end-market for semiconductor sales (0% QoQ/-3% YoY). Slackening PC sales and gaming will also have a negative effect. An increase in COGS due to inflationary pressures will continue to cut into earnings.

Communication Services?sector revenue will suffer as ad spending decreases once stronger than expected economic headwinds cause businesses to adjust costs. Entertainment spending is a mixed bag; summer box office releases were half of 2019, and movie ticket sales fell during the summer (-45% QoQ/17% YoY), although amusement park and concert attendance bettered. Bright spots are the increasing shift into digital advertising and programmatic spending (i.e. ad-supported tiers from Disney+ and Netflix).

Energy?sector revenue will be lifted by still elevated commodities prices (-6% QoQ /52% YoY%). Additionally, there was broad-based expansion in production (4 QoQ%/7 YoY%) while a marked shift from crude oil to natural gas occurred. Earnings will be affected by supply chain costs, particularly for oil & gas support services companies.

Utilities?sector revenue will gain based on increased electricity rates (2% QoQ/8% YoY) approved by public commissions. Soaring natural gas and coal prices (3% QoQ/14% YoY) will last until the end of the year, so upward revisions for rates and guidance are expected. Earnings will be influenced by higher operation, maintenance, and borrowing expenses.

Real estate?sector revenue is highly rate-sensitive and expected to decline. Deal volume amongst commercial and residential (-4% QoQ/-17% YoY) spaces dropped throughout the summer. REITs bright spots include industrial due to tight warehouse space and telecom due to wireless network infrastructure expansion. Earnings will be burdened by escalating financing costs; debt is a bigger portion of the balance sheet relative to other sectors.

Consumer Discretionary?sector revenue will benefit from increased pricing but take a hit because of rising costs. Homebuilders' subindustry revenue upside has limits due to more cancellations. Earnings will take a hit from price reductions in backlog and new units (-1% QoQ/12% YoY), mortgage buydowns, and other incentives. Leisure services subindustry revenue, like hotels and casinos, benefited from summer travel but are labor-sensitive, so earnings are susceptible to greater labor expenses.

Consumer Staples?sector revenue, typically inflation resistant, should experience stable growth as it contains necessities. Despite rising prices, consumers spent on groceries and personal care items (2% QoQ/6% YoY). Retailers with private labels will perform better in current inflationary conditions. Earnings will be mixed as companies battle passing on costs to customers.?