As we enter the third-quarter earnings season, investors and traders are eagerly awaiting the reports from S&P 500 companies in the coming weeks. This season brings a new factor that can influence market returns, going beyond economic data, Federal Reserve announcements, and current events.

Will the Earnings Recession End This Quarter?

According to analysts’ estimates, third-quarter earnings are currently predicted to decline by 0.8% YoY. If this holds true, it would mark the fourth consecutive quarter with negative earnings growth. However, research suggests that companies tend to manage expectations by underpromising and then overdelivering (with around 70% of companies beating expectations each quarter). Therefore, there’s a high possibility that as more companies report, we could see a return to positive earnings growth.

If this happens, it would signify the end of the earnings recession. Regardless, starting next quarter, earnings are expected to ramp up, with an average year-over-year growth of 10% over the next year.

Positive Earnings Momentum in Most Sectors

A closer examination of the third quarter reveals a similar trend to the second quarter, with three sectors seeing negative growth and all other sectors experiencing positive growth (chart below).

The negative performers in Q3 are the same as in Q2:

• Health Care: Lower uptake of Covid boosters and testing has led to a decline in health care spending.
• Energy: Prices have fallen as the impact of the Ukraine war fades, with oil prices down 12% YoY and natural gas prices down almost 70% YoY.
• Materials: The shift from goods to services as the economy reopened has hurt demand for goods, leading to an ongoing recession in manufacturing activity that began in Q4 2022.

Consumer-Driven Sectors Stand Out

The sectors with the highest growth rates are consumer-driven. Communication Services (including companies like Netflix, Disney, and Activision) is expected to achieve more than 30% YoY growth, while Consumer Discretionary (including Amazon, Travel, and Restaurants) is projected to see over 20% YoY growth.

These numbers align with the retail sales data, which shows that consumers are continuing to increase their spending, defying expectations. The strength of the consumer is a vital reason why the economy is avoiding a recession.

The most recent retail sales data confirms this trend, with consumer spending rising by 0.7% from August, surpassing consensus expectations (chart below, blue line). Over the last quarter, consumer spending has grown at an annualized rate of almost 9%.

The majority of this growth can be attributed to online shopping, restaurants, and entertainment (as well as gasoline, due to rising prices from Q2 to Q3), which aligns with the performance of Communication Services and Consumer Discretionary. However, spending on durable goods, such as furniture, has declined.

Strong Consumers Increase Chances of a Soft Landing

The ongoing strength of consumer spending plays a significant role in the likelihood of a soft landing for the economy, especially considering that consumer spending contributes to approximately 70% of GDP. Following the release of the retail sales data, Q3 GDP estimates have been revised upward to 5.4% annualized growth from 5.1%.

However, if increased spending leads to inflation, there is a higher possibility of another Federal Reserve rate hike. That’s why the stock market initially reacted by selling off and interest rates rose in response to the retail sales data.

Recent data also indicates that consumers have more savings from the Covid pandemic than previously estimated—potentially over $1 trillion. This puts consumers in a better position to withstand the headwinds expected in Q4, such as the resumption of student loan payments, ongoing UAW strikes, and a potential government shutdown.

If consumers remain resilient, it will have a positive impact on earnings in Q4, which, in turn, will benefit stocks in the long term.

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