Macro Headwinds Take Toll on Profit Growth

Corporate profits continued to slow in the third quarter amid high inflation and the fight to subdue it. In the U.S., 69% of companies beat analysts' earnings expectations, lagging last quarter and trailing the long-term average. Meanwhile, 61% of European companies exceeded expectations.¹

In the U.S., the tepid 2.2% earnings growth rate is even weaker than it appears. If we removed robust energy sector profits, which were up more than 137%, earnings would have declined more than 5%. Similarly, overall profit growth was 22% in Europe but only 7% when we excluded energy sector data.² See Figure 1.

Inflation Simultaneously Helped and Hurt Results

Though earnings growth moderated, U.S. revenue growth remained relatively strong at more than 10%. It was the seventh consecutive quarter of double-digit growth, with all sectors delivering increases.³ Because sales are a function of price and volume, rising inflation was a strong tailwind for revenue. On the downside, however, weaker earnings data reflects the drag of inflated input costs and wages.

Still, profit margins remained healthy. Companies have generally been able to pass through higher costs without destroying demand, though cracks may be starting to show. The S&P 500 profit margin was 11.9%, down slightly from the same quarter last year. Looking closer, however, strength in the energy sector is again masking weakness almost everywhere else. More than half the companies in each sector reported lower profit margins outside energy and industrials, as shown in Figure 2.⁴

Revenue growth has been robust in Europe and Japan, with the short supply of goods and high demand allowing companies to raise prices and grow their profit margins. Risks are rising, however. Consumer demand is weakening, and with supply chain issues abating, inventory levels are high. These shifts could make it harder for companies to pass on higher costs and sustain their record profit margins.

Five Earnings Season Themes We're Watching

1. Higher Rates Are Having Mixed Impacts on Financials

The fundamental performance of banks, especially those levered to deposits and lending, benefited from higher interest rates. Meanwhile, declining deal-making activity hurt those with heavier exposure to investment banking. We're also seeing loan loss provisions rise in anticipation of tougher economic conditions, a turnaround from muted provisions a year ago.

Management Comment on Preparing for a Recession:

"We've got our recession playbook. You have a credit cycle playbook, and we'll pull that playbook lever if we need to pull it, but to pull it at this particular point in time doesn't make any sense. We're seeing strong growth, and we're seeing strong credit results overall, so right now, nothing new."

Stephen Squeri, CEO, American Express

2. Pricing Power for Some but Not Necessarily Volume Growth

The ability to pass on higher raw material costs has generated higher revenue growth for many companies in the consumer staples sector, from packaged food companies to household products. However, volume growth was muted and, in many cases, negative.

Spirits makers, including Pernod Richard and Diageo, have been able to raise prices and increase the volume of goods sold. In China, demand remains strong despite COVID lockdowns. Alcohol is typically less price elastic than other consumer staples and considered an "affordable luxury."

Management Comment on Consumer Preferences:

"We are also seeing consumers moving two different price points, so a group of consumers is looking for value by trading into higher transaction sizes to find lower cost per use or lower cost per unit, and we see other consumers who are more cash conscious, and they are very focused on cash outlay … The strategy to provide pack sizes that stretch from below $10 for some channels and consumers to above $30 or $40 for others seems to be meeting consumers' needs."

Andre Schulten, CFO, Procter & Gamble

3. Warnings About Slowing Demand

Slowing demand weighs on many companies, including so-called "big tech" firms. The quarterly updates from Microsoft, Alphabet, Amazon and Texas Instruments underscored growing pressure on everything from corporate information technology budgets to digital ad spending and chips used for industrial machinery.

Management Comment on Capital Spending:

"My conversations with CEOs, they tell me that they are rethinking business opportunities and would like to see more certainty before committing to longer-term plans. As we head into the fourth quarter, my sense is that the outlook will remain unsettled, though economic performance will vary by region and also expect volatility to persist as markets continue to digest these factors."

David Solomon, CEO, Goldman Sachs

4. Digesting Overstocked Inventory

Overstocked inventories have weighed on earnings. Many companies double-ordered during the pandemic to deal with supply scarcity. Now, the practice of double ordering is coming home to roost as businesses must trim inventory levels to reflect slower demand. This theme is playing out among consumer goods, semiconductor, industrials and health care companies. Consumer goods companies, in particular, will likely face heavy discounting over the next few months.

Management Comment on Excess Inventory:

"The promotional environment continues to be considerably more intense than last year. Like Q2, the level of promotionality in Q3 was similar to pre-pandemic levels, and in some areas, was even more promotional as the industry works through excess inventory in the channel as well as response to softer customer demand."

Corie Sue Barry, CEO, Best Buy

5. Hybrid Travel

Business travel is coming back, and leisure travel remains strong. Due to the flexibility of hybrid work, there have been permanent structural changes in leisure demand. Remote work allows for the blending of business and leisure.

Management Comment on Blending Business and Leisure Travel:

"With hybrid work, every weekend could be a holiday weekend. That's why September, a normally off-peak month was the third strongest month in our history. People want to travel and have experiences."

Scott Kirby, CEO, United Airlines

Outlook: Profit Expectations Are Heading Lower

We expect the weak earnings trends of the last few quarters to continue showing up in fourth-quarter results and for the calendar year 2023. A recent estimate is for U.S. profit growth to fall 1.7% in the fourth quarter compared to a year ago.⁵ This number reflects a significant downward revision from expectations at the beginning of the earnings reporting season.

Analysts forecast strong growth for the energy sector, but lower than what we've seen in previous quarters. We expect every other sector to see slower growth than initially thought, with only energy, industrials and real estate projected to post earnings growth.

So far, forecasts for 2023 earnings growth for the S&P 500 remain positive, though lower. The consensus estimates may prove too optimistic, however, as slowing economic growth and higher inflation expectations may take a bigger bite out of U.S. company earnings.

As shown in Figure 3, it has been rare, outside recessions, to see earnings estimates fall as much as they have in the last five months.

In Europe, the earnings downgrade cycle has started. After two years of upgrades that lifted the Stoxx 600 estimates 80% above the 2020 trough, there are signs that the earnings cycle is beginning to roll over, and momentum has turned for the first time since August 2020.

While consensus expectations for Stoxx 600 EPS growth in 2022 remain near a record high, those for 2023 have fallen to the lowest level since 2009 (excluding the 2020 COVID shock).