Heading into this week, some 117 S&P 500 companies comprising 33% of S&P earnings had reported results so far. Superficially, the report so far have come in better than expected tracking a 4% beat ($50.91), driven by Financials (+13%) and Energy (+7%) despite mounting concerns ahead of earnings about stagflation and shrinking profit margins. The proportion of beats also remained strong – 79%/72%/62% of companies beat on EPS/sales/both, well above the historical average of 63%/57%/43%, but slightly below last quarter’s 82%/82%/72%.
And yet, despite the strong early showing in Q3 earnings season, storm clouds are starting to emerge.
According to calculations from Bloomberg, with just under of 30% of the benchmark’s members having announced results, the S&P500 is currently on pace to see its profits grow by less than 1% from the second quarter. That would be the smallest quarterly increase since the height of the Covid-19 pandemic sent corporate earnings plummeting early last year.
(As an aside, stronger-than-expected results from both Microsoft and Alphabet could help widen that margin, Bloomberg's Matt Turner writes, noting that the tech pair’s combined profits are expected to account for about 12% of the S&P 500 remaining profits this quarter, despite having more than 350 other members on the gauge yet to report. Incidentally, analysts are expecting Google to deliver earnings growth of nearly 64% for the period. Meanwhile, forecasts for Microsoft are slightly less bullish, only calling for a jump of about 14% versus last year.)
Digging deeper, we go to Morgan Stanley's Michael Wilson who as we noted earlier remains bearish, and pointed to not only the recent flattening out of estimates, but warned that fwd EPS has continued to rise at a slower rate. Perhaps most concerning is that earnings revisions breadth - a key leading indicator - is now falling rapidly for almost all sectors. And since revision breadth is a very good leading indicator for NTM EPS, it's only a matter of time before NTM EPS begin to decline for reasons including higher costs, supply issues and taxes to a payback in demand that should begin in 1Q.
The biggest threat, however, remain supply chain constraints which pose a risk not only to 3Q earnings and but also forward-looking earnings revisions breadth. As the chart below shows, corporate transcript mentions of "supply chain issues" are at unprecedented levels, while ISM lead time indices across both manufacturing and services are also historically stretched. As excerpts from recent earnings calls (below) reveals, these issues are being discussed by companies in a wide range of industries.
Responding to frequent client questions, where the most prevalent inquiry is "aren't these risks already in consensus estimates and multiples given these issues have been discussed all year" Wilson says that prior to his work over the past several weeks, he would have made the same assumption. However, 3Q EPS expectations remained extremely resilient into the quarter and as the next chart shows, 3Q EPS expectations for this year actually saw their largest upward revision on a YTD basis since 2002.
This is a problem because as we showed on Friday when demonstrating the market's panicked selloff on earnings misses, bad news are hardly priced in. Wilson agrees and over the weekend he updated his analysis of EPS surprise, sales surprise and T+1 day price reaction of 3Q reporting companies that discuss supply chain risks on earnings calls. Confirming what we reported, Wilson writes that "relatively lackluster beat rates and outright negative price performance T+1 day continue to be the trend for these companies. As we move into the heart of earnings season over the next 2 weeks, we expect this to continue to be a dominant narrative, especially as we move past the bulk of Financials (where we're overweight) reporting and into the cohorts that are more sensitive to these risks."
As the MS strategist further elaborates, "companies that have posted negative 3Q EPS surprises have seen historically poor price performance 3 days after reporting (Exhibit 8). This offers some further confirmation that bad news on the earnings front, isn't already in the price." On the other hand, companies that are beating on earnings have seen less of the positive price reaction above what they typically see (Exhibit 9). Indeed, as we said above, "a lot of good news is priced, while the bad is largely not."
Which brings us back to the big question: will supply chain constraints and associated disappointing reports be enough to affect the price level of the overall index? That remains to be seen. At we touched upon earlier when discussing Wilson's broader bearish bias, the MS strategist is leaning more toward the idea that we would "need to see retail activity diminish and higher bond yields in concert with these earnings risks in order to lead to a more meaningful selloff in the index."
That said, a key message from Wilson over the next several weeks is "to stay selective and to stay more defensive in terms of positioning." He continues to prefer "relatively reasonably priced" Software over Hardware and Semis in Tech, Services over Goods in Discretionary, Financials and Healthcare. Why? Because "these cohorts offer less direct risk to supply chain issues and in the case of Healthcare and Software (relative to broader Tech), offer a more defensive posture."
Which brings us to some some select corporate quotes on supply chain issues from 3Q earnings season so far:
- SON: "At a high level, we experienced strong volume growth in many of our businesses, but our third quarter operational results continue to be impacted by significant cost inflation and supply chain challenges."
- FR: "There's so many issues in the supply chain right now and there's strong demand. So we hope that this level's off for our tenants' sake. But the reality is I don't think it will level off. I think it will – the supply chain issues will continue and the rent pressure will continue because the lack of space and increased demand."
- POOL: "Inflation this year will likely be in the 6% to 7% range, up from our previous estimate of 5% to 6%, and it looks like that will repeat again for next year given the global supply chain issues."
- GPC: "In our customer discussions, a recent common theme is the supply chain challenges that face all companies."
- UNP: "We expect international volumes to be constrained as ocean carriers have recently taken additional actions to speed up their container returns as challenges in labor, port capacity, warehouses and dredge persist. And on the domestic side, opportunities will face continued supply chain challenges with limited haul-away capacity and slower chassis turn times."
- SNAP: "We've been meeting with a lot of advertisers, and had a lot of meetings here, and we're hearing from partners across a wide variety of industries and geographies that they're facing headwinds in their business related to the disruptions in global supply chain as well as labor shortages and labor competition. So when they're talking about the product, putting marketing into the product when there's already low margin, for instance, can erode margin. And furthermore, they don't necessarily want to accelerate the sales of products that they are going to have a hard time getting into the hands of customers. And that is somewhat broad sweeping in terms of the supply chain issues."
- BKR: "Operating income for the quarter was $26 million, down 44% year-over-year, largely driven by headwinds from mix of volume, supply chain challenges, and higher R&D costs."
- DOV: "So let's get on the front foot here by providing some color on inflationary inputs, labor and supply chain challenges...Let me start by saying that we're particularly concerned that there have been no discernible policy changes, particularly in the US to deal with these headwinds, and in fact, many proposed policies run the risk of extending their duration."
- RPM: "Raw material shortages and inflation continue to be serious challenges. In order to protect our margins, we are continuing to implement price increases, where appropriate, across all our segments."
Supply chain issues (and the duration of such production bottlenecks) aside, Wilson writes that "it's becoming increasing clear to us that 3Q EPS disappointment (which is largely being attributed to supply and cost issues), has the potential to affect forward looking EPS growth expectations as well."
In contrast to the first week of reporting season when the banks posted standout results and revisions breadth ticked higher, last week saw a lot of companies discussing supply issues as a continued and more pervasive risk than initially thought. The result, as Morgan Stanley notes, is plunging earnings revisions breadth for many sectors and the S&P 500 overall.
Indeed, bottoms-up analysts are beginning to think that these issues may persist beyond just a quarter or two. The chart below shows earnings revisions breadth for the S&P 500 (which is based on FY2 or 2022 numbers in this case). This series is starting to decelerate and is currently at its lowest level since last summer. This indicator is key because it has a strong positive correlation with index price so further deterioration here is critical to watch.
The final chart shows this trend across industry groups and sectors. As Wilson notes, this deceleration is a fairly broad dynamic across these cohorts, which speaks to the reach of these supply chain and cost pressure issues.