Earnings Reports Start Well But Stocks Sink on S&P 500

As previewed last week, earnings season began with 15 S&P 500 companies reporting, with banks and financials dominating the total. Last week, the S&P 500 fell over 2%, with bank shares fairing slightly worse. The pace and the breadth of the first-quarter earnings season increase this week, with 68 S&P 500 scheduled to report. Only 7% of S&P 500 companies have reported results so far, with 77% and 80% exceeding consensus earnings and sales estimates, respectively.

At this early juncture, blended earnings, which combine actual with estimates of companies yet to report, are mixed relative to forecasts at the end of the quarter. The growth rate for the industrials remains misleading this quarter since several companies in aerospace/airlines reported a loss in the first quarter of 2021 and should improve or post a profit this quarter. According to FactSet, if six aerospace companies are excluded from the growth calculation for the quarter, the year-over-year growth rate for the sector falls to 3.4% from 31.6%. The Real Estate sector also benefits from easier comparisons since covid weighed on hotel and resort occupancy in the first quarter of 2021.

The blended revenues paint a better picture, with most at or better than estimates at the end of the quarter. Sales in the energy and materials sectors illustrate the robust increase in commodity prices. The only S&P 500 sectors with price gains year-to-date are energy, utilities, and consumer staples.

As expected, the earnings performance has exceeded expectations at the end of the quarter. Combining actual results with consensus estimates for companies yet to report, the blended earnings growth rate improved to 5.1% year-over-year versus the expectation of 4.7% at the end of the quarter.

Bank and financial earnings dominated the first week of the earnings season. Aside from JPMorgan (JPM), bank earnings were better than expected, leading to a sizable improvement in the blended earnings growth rate for the financial sector. JPMorgan’s headline earnings were disappointing, but core earnings (removing some non-core losses and charges) were in line. Using JPMorgan as an example for the banking sector, earnings were a mixed bag. Net interest margin (NIM), the spread a bank earns in interest on loans compared to the amount it pays in interest on deposits, improved. Loan balances were slightly negative quarter-over-quarter. Trading revenue was better than expected. Goldman Sachs (GS) also had better than expected trading revenue, driven by currencies and commodities. The headline year-over-year earnings decline for the banks should remain grim since significant loan loss reserve reductions in the first quarter of 2021 make for difficult comparisons. In addition, the beginning of loan loss reserve building this quarter makes the comparison even more formidable. More banks and financials report this week, including Bank of America
BAC
(BAC), Schwab (SCHW), American Express
AXP
(AXP), and several regional banks.

Banks had benefited from the rising tide in yields. Until early March, the relative performance of bank stocks had followed the path of interest rates since the end of 2019. So what changed?

The divergence between the 10-year Treasury yield and the relative performance of bank shares corresponds with the market beginning to price in a very aggressive rate hike path from the Federal Reserve to combat inflation. While the yield curve had been flattening for some time, the difference between the yield on the 2-year U.S. Treasury and 10-year fell below a quarter of a percentage point. Taken together, this raised the probability of a future recession and more than offset the tailwind that banks were getting from improved net interest margin based on the higher yields. It will be exceedingly difficult for the Fed to engineer a soft landing for the economy while needing to tighten monetary policy aggressively to fight inflation. Bank shares are currently caught in the tug of war between the current benefits to profitability from the rate hikes and a future possible economic downturn that will cause increased loan losses.

While it is still very early, earnings have remained robust, and more than three-quarters of companies have exceeded earnings estimates. Generally, while cost pressures have increased, strong demand and improved productivity have allowed companies to grow earnings despite the headwinds. This week a more diverse group of companies outside of primarily financials reports earnings, so it will be instructive if this narrative continues to hold. Outside of earnings season, Fed Chair Powell will speak on Thursday, and market participants will be listening for clues about the size of the interest rate hike at the May 4^th meeting and the future path of rates. Fed funds futures are already pricing in a 50 basis point, or 0.50%, move in May and almost wholly priced in another in June.