Earnings Growth Positive, but Uneven

U.S. earnings growth remained in positive territory during the fourth quarter of 2023, coming in ahead of analysts’ expectations at 4.1%. Japan and emerging markets also delivered positive results, with 10% and 8% profit growth, respectively. Earnings growth in Europe remained negative at -11%.¹

Though U.S. results were positive, the number of companies beating profit and sales expectations was below average. The magnitude of the earnings beats was below average as well.²

We’re seeing indications that companies are having a harder time passing along higher costs to their customers. Though revenue rose again, profit margins continued a negative trend, below the five-year average.²

Meanwhile, sales growth was negative in Europe and is on track to reach its lowest level in nine quarters. Analyst consensus estimates reflect expectations for earnings weakness to continue well into the second half of the year.³

On the positive side, the impact of resilient consumers was on display in both the U.S. and Europe. Strong results from broadline retailers again drove average profits for the S&P 500^® Index average higher.

Amazon was the key player in the sector. It had a whopping 3000% improvement compared to Q4 2022, when profits fell due to a decline in the value of its stake in electric car company Rivian. Strong results from hotels, restaurants and leisure companies also helped propel the consumer discretionary sector.²

Rolling Earnings Recession Continues at the Sector Level

The fourth quarter marked the second consecutive quarter of positive earnings growth in the S&P 500 after three quarters of contraction from Q4 2022-Q2 2023. However, the recovery in the top-line numbers distorts significant differences at the sector level due to the timing of disruptions and recovery from the pandemic.

For example, in technology, earnings growth remained strong during the early days of the pandemic as demand for equipment to enable working and learning from home was high. Still, demand slowed in late 2022 and early 2023 as inventory built up and demand softened. Only recently have earnings strengthened, due mainly to AI-related spending.

Consumer discretionary earnings fell significantly as the global economy initially shut down but then recovered quickly as consumers began to spend down extra savings accumulated from government stimulus payments.

Health care reported some of the strongest earnings growth during the pandemic but has been one of the weaker sectors for earnings growth in recent quarters as demand for COVID-19 vaccines and treatments declined significantly. As represented by the green bars in Figure 1, year-over-year earnings growth in the sector has declined for six consecutive quarters.²

Four Trends We’re Watching

1. AI Remains at the Forefront

Artificial intelligence remains a key theme in European earnings call transcripts. Companies are increasingly discussing how to implement AI solutions to drive productivity gains. The continued focus on AI may help relieve the oversupply of semiconductors, which caused chipmakers’ production rates and volumes to decline in previous quarters. During the most recent round of earnings calls, chip companies reported that their customers have sold off some excess inventory, improving the outlook revenue and profit growth from chip production this year.

2. Magnificent Seven Stocks Are Propping Up S&P 500 Earnings Growth

The seven largest companies in the S&P 500 Index continue to drive its price performance and earnings growth. Amazon, NVIDIA, Meta Platforms, Microsoft, Apple, Alphabet, and Tesla not only reported relatively strong year-over-year earnings growth — Tesla was the exception — but they also represented 28% of the S&P 500 index weight.²

The Magnificent Seven’s contribution to the overall growth of blended earnings was significant. As illustrated in Figure 2, the Magnificent Seven contributed 8.97% of the overall 4.13% earnings growth. The other 493 stocks contributed -4.84%.²

3. Companies Are Reducing Headcount to Manage Expenses

Profit margins have been trending lower in recent quarters as pricing power slows. At the same time, labor and input costs remain elevated. Companies that announced workforce reductions include Alphabet, Amazon, Cisco, Citigroup, DocuSign, eBay, Microsoft, Snap, UPS, Wayfair and Zoom.

4. Challenges Continue in China

The tone of corporate executives on China remains mostly negative. There was little indication of whether the bottom was near in China. Companies based there or tied to Chinese consumers continue reporting a difficult operating environment. China is seeing pressure on growth from both the manufacturing and services sectors. Consumer sentiment is weak due to the ongoing real estate crisis and high youth unemployment. The manufacturing sector suffers from weak exports, geopolitical tensions and a lack of stimulus.

Are Earnings Expectations Too Optimistic?

The percentage of companies issuing negative forward guidance this quarter worsened amid the uncertain economic outlook. Not every company provides a forward-looking perspective on its earnings, but 69% of companies that have issued guidance provided lower-than-expected forecasts. That’s more than last quarter and well above the five-year average of 59%.²

The forecast is for S&P 500 earnings to rise 3.5% in Q1 2024. Analysts expect earnings to rise marginally throughout the year as input costs normalize and comparisons against the prior year become easier to match or beat.² Meanwhile, European profit growth expectations have experienced slightly larger cuts than the U.S., Japan and emerging markets due to further softening in global growth.³

However, many market participants view the U.S. earnings outlook with some skepticism in the face of an aging business cycle, restrictive monetary policy, dampened fiscal support, global growth headwinds and negative operating leverage risk surrounding disinflation.

Stocks may be priced for perfection. As shown in Figure 3, valuations have climbed above last year’s peak, raising the risk that the market could turn volatile if earnings don’t exceed expectations in 2024.²