Investors Eye Profit Rebound After Yearlong Earnings Recession

Stock bulls reeling from the worst month of 2023 have at least one reason for optimism: Corporate profits are set to rebound sharply in the fourth quarter.

Net income at S&P 500 companies is projected to grow about 7.6 per cent year over year in the period, snapping a run of four straight contractions, according to data compiled by Bloomberg Intelligence. Third-quarter earnings reports that start in earnest next week are likely to show profits fell slightly — 0.3 per cent, based on the data — but that’s also still a quick rebound from the 5.7 per cent profit drop of the previous three months.

A bounce-back in profits would be a lifeline for investors unsettled by a two-month selloff in the S&P 500, which is portending diminishing hopes of an economic soft landing in defiance of the United States Federal Reserve’s aggressive hiking cycle. On Oct. 3, the benchmark slumped to its lowest level since June after a surprising increase in U.S. job openings.

The upbeat profit forecast suggests companies that struggled to defend margins as inflation flared the past two years are now enjoying the benefits of a slowdown in the rate of price growth. They are also cutting costs to offset the impact from higher-for-longer interest at the same time that the American consumer continues to spend at relatively stable rates.

“High inflation resulted in margin compression for non-energy companies,” Bloomberg Intelligence global chief equity strategist Gina Martin Adams said. “Now, slowing inflation, combined with the lagged effect of last year’s layoffs, is resulting in margin expansion for the same.”

Communications and utilities, with estimated earnings gains of at least 45 per cent each, should power the fourth-quarter recovery. The rebound signals a changing of the sectoral guard as last year’s profit laggards bounce back, while others struggle to match rapid growth from a year ago.

Chipmakers and media and entertainment players are expected to grow earnings by 28 per cent and 66 per cent, respectively, in the fourth quarter after declining 23 per cent and 34 per cent over the same period last year. The S&P 500’s profit outlook would be even rosier — 11 per cent growth — if energy companies were excluded. They’re expected to shrink 24 per cent year on year in the fourth quarter due to tough comparisons.

Still, equity investors and strategists have a plethora of reasons to remain cautious: the possibility of more interest rate hikesrecession warningsprolonged labour strikes, higher energy prices, dwindling consumer savings and the resumption of student loan repayments.

Plus, the profit recovery at America’s largest companies may not filter through to small-cap stocks. Manish Kabra, chief U.S. equity strategist at Société Générale SA, sees the Russell 2000 index’s 1.9 per cent drop so far this year as a possible warning sign. Smaller firms employ almost half of the U.S. workforce and are more sensitive to rising interest rates, which raises their cost of borrowing, erodes profits and prevents or delays expansions.

Scott Ladner, chief investment officer at Horizon Investments LLC, said the Fed’s hawkish stance heralds the expected profit rebound as it reflects confidence in the economy.

“They’re saying, we think that the economy is gonna be stronger overall. And so we’re going to keep rates a little bit higher for a little bit longer,” the manager of about US$7 billion of assets said. “We think the market will come to grips with that during the fourth quarter.”

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