Earnings Outlook: Big Banks Kick Off Q1 Earnings Season

Summary

• Friday’s employment report and recent earnings show the underlying economy remains on solid footing.
• The broader equity markets remain buoyant on hopes for a rate cut. We expect equities to remain rangebound, with risks tilted to the downside.
• The banking sector still trades near the bottom of the range that prevailed after Silicon Valley Bank’s failure. Perhaps Q1 earnings (coming on Friday) will reinvigorate at least the major banks. We maintain our long bank position.
• The NASDAQ 100 (NDX) has rallied on AI excitement but now looks overvalued relative to projected earnings and the S&P 500 (SPX). We maintain our long SPX vs short NDX position.

What We Learned Last Week

The US labour market remains robust, with a net gain of 236,000 jobs revealed on Friday. Granted, that continues a downtrend over the past year – but it is still impressive given the tepid growth in US population and swelling retirement-age subsection. Even allowing for job growth tilted more toward lower-paying service jobs, the economy is still on solid footing, with consumption rising in real terms.

And companies continue to report earnings meeting or beating forecasts, along with outlooks that factor in little risk of recession in 2023.

Markets sold off modestly after Friday’s employment report, but the S&P 500 (SPX) and NASDAQ 100 (NDX) remain near 2023 highs. The losers in recent weeks have been banks (Chart 1) and the small stock-focused Russell 2000 (RTY), which is near 2023 lows on concerns about a cutback in bank lending by regional and community banks.

On 29 March, we moved to an overweight on the major money centre banks. Our rationale was that the selloff following the Silicon Valley Bank (SVB) failure was overdone and that banks will soon recover. Money centre banks are currently trading near the top of the post-SVB range, while regional banks still struggle. The regional bank ETF KRE dropped 3% over the past week. As we discuss below, the next milestone for the banking sector (especially money centre banks) comes later this week when they start reporting Q1 earnings.

Why We Are Not Bullish on Equities

Given the generally constructive tone in equities (apart from banks), why are we not more enthusiastic about equities?

First and foremost, we do not think the Fed will cut in 2023. Much of the enthusiasm stems from hopes the Fed will pause its rate hikes after its next meeting on 3 May and start looking for reasons to cut rates. Markets have been consistently looking for the Fed to take a dovish stance on rates for much of the past year even as inflation has remained stickier than the Fed (or markets) hoped.

We will not attempt to predict inflation. But we will say that if the Fed is serious about corralling price rises, it will not think about cutting rates until inflation has dropped below 3% and shows clear signs of falling further. In every past rate tightening cycle, the Fed raised rates well above the inflation rate to control it. Rates are still well below that level.

If the Fed does ease while inflation is still on the hot side (perhaps to ease tensions) it may well box itself into having to raise rates considerably higher later on to prevail over inflation. Yes, equities will initially rally in that scenario but if inflation shows signs of rising again or is just plain sticky that rally will likely prove short-lived.

Second, a credit crunch is still possible. Whether the recent pullback in bank lending is temporary or develops into a full-blown credit crunch is unknown. For now, we see risks tilted to the downside. If that scenario does develop, look for unemployment to rise and earnings to drop.

Third, soft earnings may outweigh AI enthusiasm. The tech rally is due partly to excitement about the prospect of AI and Chat GPT-related technology. But when earnings start to flow in coming weeks, they may reveal that the more prosaic side of the business is still suffering from weak ad volumes/revenue and soft consumer demand – and that profits from AI tech are distant.

By our measure, the NDX is overvalued by 25% relative to projected earnings. The forward P/E relative to SPX is about 1.3 – near the high of the past decade. A lot must go right to support that valuation.

Our long SPX/short NDX position has underperformed over the past six weeks, but we are maintaining it on expectations that NDX will correct soon.

On balance, we expect equities to remain in the trading range of the past nine months, with risks tilted toward the lower end of the range.

The Week Ahead

It will be another light week for earnings, with only 12 companies slated to report as Q1 earnings season starts. But it will be a consequential week, with several banks reporting on Friday.

Tuesday

• With the Manheim used car index up 8.5% so far in 2023, CarMax Inc (KMX) will indicate where demand for autos is coming from and whether this is sustainable.

Thursday

• Given First Republic Bank’s (FRC) stock remains stuck at the low point of the ongoing bank crisis, most investors clearly think it will not be a going concern for long. Is there anything it can say to restore confidence?
• Delta Airlines (DAL) gives a key update on expected summer traffic.
• Fastenal Co (FAST) is relatively unknown, but the industrial demand for its products will be an essential clue in the economic outlook in coming months.

Friday

• The banking crisis may have come late enough for Citigroup (C), JP Morgan Chase (JPM), PNC Financial (PNC), and Well Fargo & Co (WFC) results to reflect the pre-crisis economy – and be solid. So the question will be whether banks expect to maintain that momentum. As a regional, PNC outlook will be particularly of interest.
• Blackrock Inc (BLK) is usually one of the headliners, but this time it may be more of an afterthought – although comments about inflows to its money market funds may be of interest.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)