Earnings Season Dilemma: Is Q3 Earnings Optimism Fueling a Market Rally or Brewing Uncertainty?

by Investment Analyst, Danish Lim

Earnings season started last Friday and while we saw strong earnings results from banks, markets have been struggling for direction due to concerns about interest rates staying “higher for longer”, as well as geopolitical risks related to the Israel-Hamas conflict. As a result, any upside price reaction from strong earnings may be limited, and the downside price reaction could become more pronounced. As such, market conditions are expected to remain choppy as investors continue to weigh these external factors against earnings releases.

Wells Fargo and JP Morgan kick-started the 3^rd Quarter earnings season last Friday by posting profits that are better than expected. We believe that other major US banks are likely to follow suit and post similar results. A key reason for the strong financial performance posted by the banks is because higher interest rates have led to an increase in Net Interest Income (NII)- which is the difference between the interest that a bank earns on loans and the interest that they pay out on deposits. Essentially, bigger US banks like Wells Fargo and JP Morgan were able to charge more interest on loans while at the same time raising the rates that they paid on deposits slowly. This led to better than expected profits.

Furthermore, they have a diversified revenue stream and other fee-based sources of income, such as investment banking, asset management, and trading. They earn fees from underwriting and facilitating mergers & acquisitions, as well IPOs. However, it might tougher for smaller regional banks to replicate this success, due to their funding costs being higher and the lack of diversified income sources, as compared to the bigger banks.

In addition to the banks, numerous consumer-centric companies have recently released their Q3 earnings too.

Firstly, UnitedHealth Group, a leading healthcare insurer in the US, surprised on their earnings;  resulting in a 4% leap in its share price. This comes despite the fact that more seniors are starting to opt for elective surgeries that they previously delayed during the pandemic, which many believe would have increased insurer’s medical costs due to more medical claims. Hence, the recent results from UnitedHealth demonstrate that medical costs have stabilised, countering public pessimism.

Secondly, Procter & Gamble also reported strong financial results, as its share price surged by +2.58% last night during post-market trading. The company’s strong performance can be attributed to inelastic demand for essential products like shampoo and toothbrushes. Consequently, P&G managed to offset  rising input costs by implementing price hikes for its products. Thus, P&G has demonstrated strong pricing power, as higher prices are still tolerated by customers.

Lastly, Netflix’s share price jumped by +12.51% last night in post-market trading, after the streaming giant beat earnings estimate. This is likely attributed to its success in cracking down on password sharing, including the introduction of a paid sharing program requiring additional fees for sharing outside one’s household. Simultaneously, Netflix launched a platform advertising feature and a basic-tier membership, enabling users to access content with paid advertisements. This approach led to an 8.76 million increase in Netflix’s subscriber base, likely due to a migration of account-sharing users. As users transition to basic accounts, it increases the available advertising inventory, boosting advertising revenue.

On the flipside, crowd-favourite stock – Tesla (-4.78%) missed estimates on both the top and bottom line for the first time since Q2 2019, which we believe is attributed to reduced vehicle deliveries. While Tesla attributed it to scheduled downtimes for plant upgrades, many also believe there is a slowdown in demand amidst stiffer competition from Chinese EV makers like BYD who have been eating into their market share. As such, we have seen Tesla repeatedly cut prices on their vehicles, which leads us to speculate that it’s an attempt on their end to drive demand.

Outside Tesla, many are also anticipating the earnings announcement of the other Magnificent Seven stocks, as they account for over a quarter of the S&P 500 market capitalisation. On average their earnings are projected to jump over 30% YoY and these companies will be under a lot of pressure to deliver strong earnings in order to justify their sky high valuations. Hence, an earnings miss from them will likely spillover into the broader market and cause a market slump.

Nonetheless, one interesting company to keep a close look-out for would be Ford, who will announcing their earning next Thursday (26 Oct). With the Ongoing strikes by the United Auto Workers (U.A.W.) union, several Ford factories across the US has been forced to shut down and estimates suggest that Ford is losing about $44 million a day due to the strikes. This is all very costly to Ford’s bottom line. Furthermore, the strikes may cause Ford to actually scale back some of their plans to further invest into EVs, causing the company to lag even further behind rivals like Tesla and BYD in the EV space.

While these companies are expected to have optimistic earnings, it would be prudent for investors to be cautious and strategic amidst a market backdrop that is being marred by geopolitics and an uncertain interest rate trajectory. A more selective approach to investment, focusing on defensive industries or sectors that have historically been resilient during volatile periods could be the key to navigating the present headwinds in the markets. Alternatively, investors should consider practicing dollar-cost averaging at this juncture- aiming to invest a fixed amount of money at regular intervals, regardless of market conditions. This will help investors overcome emotional impulses that may cause impulsive buying/selling decisions which occur frequently during volatile periods.