Earnings Season Spotlight

We have generally good news to report from corporate America as we reach the tail-end of the Q3 earnings season: FactSet is reporting that year-over-year growth in earnings is 5.4%, marking the fifth straight quarter of growth in bottom line results. Although the number and magnitude of positive surprises is below the historical average, the aggregate earnings results for the quarter are beating expectations. Interestingly, however, it is the technology sector that has reported the largest negative earnings surprises, with both Apple (AAPL) and Intel (INTC) missing estimates. Looking at overall corporate profitability, the Q3 results for the S&P 500 reflected a slight degradation in profit margins to 12.1% from 12.2% last quarter, but this represents a still-significant increase from the 5-year average of 11.5%. This dramatic improvement is directly related to the high earnings contributions and profitability of the MAG7 stocks: For context, the profit margin of these companies in aggregate is 23.5%, outpacing the roughly 8.5% profit margin of the other 493 stocks in the index.

For 2025, Wall Street is estimating S&P 500 earnings growth of nearly 16% and revenue/sales growth of 5.7%. This expectation renders the current market valuation at roughly 22X the forward earnings estimate — well above the 10-year average of 18.1X. We continue to anticipate that earnings growth and fundamental results will be a key driver of market returns in 2025, in contrast with the heavy contribution that multiple expansion has made over the past several years. The good news for investors is that fundamentals are strong and the 2025 earnings outlook is positive.

This week brought some interesting news from both Walmart and Target — the largest and seventh largest U.S. retailers, respectively — whose Q3 results appeared to be a study in contrasts. Walmart not only beat Wall Street Q3 sales and earnings estimates but also provided solid forward guidance that indicates strength will continue into 2025. In contrast, Target posted a significant earnings miss, falling 12% year-over-year. It also projected disappointing forward guidance. There are two issues at play here that are both interesting and important. First, while most U.S. retailers have been negatively impacted by the recent port action, which led to 45,000 dockworkers in the U.S. going on strike, it impacted some retailers more than others. Target relies far more heavily on imported goods than Walmart, and it felt a measurable bottom line impact. Second, the different business mixes between these two retailers were critical this quarter. While Target relies heavily on selling more discretionary items like clothing and accessories to consumers, Walmart derives 60% of its sales from non-discretionary items like groceries.

The contrast in the quarterly results points to a consumer that is more selective and spending more on needs than wants — and this preference is cutting across all income cohorts. Walmart’s earnings release noted that it is making significant market share gains from households earning more than $100,000, representing 75% of the total market share gains for the company. The profile of the ”Walmart shopper” has changed as all households, according to Walmart management, are experiencing sticker shock in grocery prices. The prioritization of necessities and price sensitivity are key trends here, pointing to the inconvenient truth that, even as inflation is falling toward the Fed’s target, the price level remains an issue for American households.

The market’s view about the Fed’s willingness to aggressively cut the policy rate has changed. Recall that prior to the Fed’s first rate cut, economic data in the U.S. was weak and there were growing fears of a recession, which led market participants to become excessively optimistic about the path of rate cuts.

The Fed is set to meet next month, and recent Federal Open Market Committee (FOMC) rhetoric, in addition to relatively strong economic data, has shifted market expectations for policy action. There will be plenty of data for the Fed to unpack prior to their scheduled meeting, including November's inflation data and the all-important monthly non-farm payroll report. Fed Chair Powell has continued to emphasize the data driven approach to setting monetary policy. That said, there seems to be a growing consensus across the FOMC that there is “no hurry,” and the market has taken heed. Expectations for a 25-basis-point rate cut have been revised down, with the fed funds futures market pricing in a nearly 45% probability that the Fed will hold rates steady in December.

Long-term interest rates have remained stubbornly high since the Fed started this cutting cycle in September, and this is being felt most acutely in the housing market, where both buyers and sellers have been eagerly anticipating relief in mortgage rates. That said, in an upside surprise, October existing home sales rose 3.4% month-over-month, which was not only an improvement against expectations, but also against last month's -1.3% pace. However, activity remains very low by historical standards. With a potentially slower pace of policy cuts out of the Fed, and the continued upward pressure on the Treasury yield curve, potential home buyers may have to wait even longer for mortgage relief.

This, in turn, will keep pressure on the rental market, where Zillow reports asking-rent increases of 3.3% in September 2024, year-over-year. Although the pace of the increase in asking-rents has abated to slightly below pre-pandemic averages, rent prices on an absolute basis are 33.5% higher than they were prior to the pandemic. For context, roughly 22 million households pay rent in the U.S., which is an all-time high, with the average monthly rent crossing above $2,000. Higher rents put even more pressure on household finances at a time when many are already struggling with the high cost of living.