The start of the US earnings season for Q2 2023 coincided with the recent downgrade of market expectations for full-year 2023 earnings. FactSet consensus data show analysts anticipate US earnings to fall 0.5% year-on-year (YoY) in 2023, before rising by more than 12% YoY in both 2024 and 2025. These forecasts have been revised downwards in the last few months.
It is important to understand the reasons behind changes in earnings growth. To do this, we decompose US earnings into trend and cyclical components using the Hodrick-Prescott (HP) filter, a widely used tool in macroeconomics. The trend component gives us information about the long-term level of earnings, while the cyclical component informs us about deviations from the trend.
Looking at the cyclical component, we observe that earnings are now below trend, coincident with a slowdown in the US economy. This is reflected by US earnings dipping below the historical trend, while the cycle component has fallen below zero indicating that earnings are currently below the long-term trend.
Forecasting model
We estimate a model for US earnings growth based on four independent variables: US GDP growth, US headline inflation, share buyback growth and the Federal funds rate. Assumptions were made about these four variables based on consensus expectations, which currently anticipate a gradual decline in US GDP growth and headline inflation to fall below 3% by Q1 2024. Markets also expect the Fed to keep interest rates unchanged for the remainder of 2023, with consensus expectations currently anticipating the first rate cut for Q1 2024. An assumption was made regarding share buybacks in line with recent trends.
Taking consensus views as our base case, we construct two alternative scenarios based on more optimistic and pessimistic conditions. In Scenario 1 we simulate an improvement in economic conditions based on inflation peaking and a rise in GDP growth in response to interest rate cuts by the Fed. Alternatively, in Scenario 2 we simulate a deterioration in economic conditions, with the Fed forced to keep hiking interest rates as inflation remains persistently high, triggering a more pronounced deceleration in GDP growth.
