US Strategy Weekly: An Important Earnings Season

This week marks the beginning of third quarter earnings season, and it will include four S&P financial companies reporting earnings this Friday. According to LSEG IBES, analysts are forecasting S&P Composite earnings per share to grow 5% YOY this quarter, led by the double-digit gains projected for the technology, communications services, and healthcare sectors. Conversely, energy sector earnings are expected to decline 3.4% and be a drag on S&P Composite earnings and only low single-digit earnings growth is anticipated for the other six sectors. Still, it may not be the results of this quarter that will capture investors’ attention. The guidance for future earnings growth is what may move markets. Keep in mind that while S&P’s third quarter earnings are forecast to grow only 5% YOY, fourth quarter earnings are estimated to increase a healthy 12.5% YOY. With the popular equity indices recently hitting record highs, double-digit earnings growth might be a necessity to keep the current advance in place. Positive earnings guidance will be particularly important since both Dow Jones S&P and LSEG IBES have been cutting earnings estimates for 2024, 2025, and 2026 for the last four consecutive weeks. See page 11. In our view, rising prices and falling earnings are inconsistent, particularly when the market’s trailing 12-month PE is 24.7 times earnings, and the 12-month forward PE is rich at 21.3 times. See page 10.

With this in mind, PepsiCo Inc. (PEP – $170.42) announced third quarter adjusted earnings of $2.31 that were above analysts’ expectations of $2.29. However, revenue growth disappointed in the quarter and the company cut its forecast for annual sales growth stating that price-conscious consumers were opting for cheaper private-label brands and hurting revenue. As a result, PepsiCo now expects annual organic revenue growth to be below its previous forecast of 4%. When banks come into focus later this week, analysts will be concentrating on changes in net interest income. Net interest income, or the difference between what banks earn on loans and what they pay out on deposits, provided a windfall for the sector as the Federal Reserve was raising rates; but September marked a big change after the Fed’s first rate cut since March 2020. Corporate guidance on net interest income, consumer loan delinquencies, office loan reserves, trading, and investment banking activity will be important for the financial sector this quarter and in the quarters ahead.

The source of the market’s recent exuberance was September’s employment report that was much stronger than expected. The 254,000 increase in payrolls and the unemployment rate falling for the second month in a row to 4.1%, pointed to a robust economy. Even the U6 unemployment rate fell from 7.9% to 7.7% in the month.

But the details of the report were not quite as hearty, in our view. The establishment survey indicated jobs grew 1.56% YOY, slightly below the long-term average of 1.69% YOY. Meanwhile, the household survey revealed a weaker employment picture, which in our view, justifies the expected revision to the establishment survey early next year. The household survey has been showing that year-over-year job growth has been less than 1% in each month of 2024. August’s household survey showed employment declined on a year-over-year basis; however, in September, the survey reported job growth improved slightly to 0.2% YOY. This poor job growth is significant because negative job growth is a classic signal of a recession. See page 3.

There has been a focus on foreign-born versus native-born employment this year because of a growing disparity between the two categories since the end of 2019. In the last 12 months foreign-born employment grew by 1.2 million to 31.4 million people; while in the same period, native-born employment fell by 825,000 to 130.6 million. Keep in mind that this data comes from the household survey which is much broader than the establishment survey which only includes workers on a payroll as reported to the state. The total number of unemployed foreign-born residents was 1.4 million in September and the foreign-born unemployment rate was 4.2%. There were 5.2 million native-born workers unemployed in September and the native-born unemployment rate was lower at 3.8%. See page 4.

The ISM nonmanufacturing index rose from 51.5 to 54.9 in September and all components moved higher. The only indices still below the 50 level were employment and order backlog. The best improvement was new orders which rose from 53.0 to 59.4, the highest reading since February 2023. The ISM manufacturing index was unchanged at 47.2, with five components rising and five declining. The biggest improvement was seen in business activity/production, which increased from 44.8 to 49.8, the best reading since May 2024. See page 5.

Employment in the manufacturing index fell from 46.0 to 43.9 and in the nonmanufacturing survey it fell from 50.2 to 48.1. These declines are in sharp contrast to September’s payroll report which was stronger than expected and makes us concerned that September’s payrolls may be revised lower. The ISM backlog of orders was the only other index in the nonmanufacturing survey that remained below 50, even though it increased from 43.7 to 48.3. In the manufacturing survey the backlog of orders was also weak, inching up from 43.6 to 44.1. Overall, the ISM reports suggested a stable economy with good growth in the service sector, stability in the manufacturing sector, but questionable growth in terms of employment. See page 6.

Consumer credit outstanding grew by $8.9 billion in August, underperforming consensus expectations and decelerating sharply from July’s upwardly revised gain of $26.7 billion. Both revolving and nonrevolving credit grew 0.6% in August versus July, and on a seasonally adjusted basis, revolving credit grew 5.4% (down from 10.7% a year earlier) and nonrevolving credit grew 1.2% (down from 1.9% a year earlier). After inflation, revolving credit grew 2.8% YOY and nonrevolving decreased 1.2% YOY. Nonrevolving credit contracted slightly in June, but falling interest rates had a positive impact on mortgage growth in July and August. The importance of consumer credit is similar to that of job growth. Deceleration precedes contraction and contraction is a sign of a recession. See page 7.

The NFIB small business optimism index was 91.5 in September, in line with the 88.5 to 91.9 range it has maintained since June 2022. This made July’s increase to 93.7 a positive “outlier.” September was the 33rd consecutive month of the optimism index falling below the 50-year average of 98. Plans for capex, employment, expansion, and inventories were somewhat lower, but little changed in the month. See page 8. Actual sales changes for small business owners fell from negative 16 to negative 17 in September and actual earnings rose from negative 37 to negative 34. Nevertheless, both remain historically weak. Sales expectations rose from negative 18 to negative 9 in September. With this backdrop it is not surprising that the NFIB uncertainty index rose from 92 to 103 in September, its highest level since data began in 2017. NFIB stated “Uncertainty makes owners hesitant to invest in capital spending and inventory, especially as inflation and financing costs continue to put pressure on their bottom lines.” See page 9.

There were no significant changes in our technical indicators this week. See page 12 to 16. In our view, stock prices should always be supported by solid earnings growth, and this makes third quarter earnings season critically important. However, earnings do not matter in a bubble market and with liquidity flowing due to monetary easing taking place in Europe, China, and the US, the path of least resistance for equities may still be up.

Gail Dudack

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