In a letter to clients on Tuesday, Bank of America strategists looked ahead to the upcoming second-quarter earnings season as investors brace for another set of results after a solid first quarter.
In the first quarter, Corporate America managed to deliver strong earnings, with earnings per share (EPS) exceeding consensus expectations by 3%. This was achieved against the backdrop of an easier year-on-year comparison, which reflects a 6% decline in the second quarter of 2023, compared to a 3% decline in the first quarter of 2023.
BofA strategists said they expect a 2% increase in the second quarter, which would be “in line with the historical average and the smallest since the fourth quarter of 2022.”
Despite a strong start, macroeconomic conditions have deteriorated since the first quarter. The Economic Surprise Index (ESI) has reached its lowest level since June 2015, indicating a potential loss of 3% in second quarter earnings. However, historical data offers some optimism: after the global financial crisis, earnings per share have exceeded expectations 91% of the time when ESI was negative, with an average of 3%.
“An EPS miss is rare,” strategists emphasized.
BofA’s Q2 outlook indicates that while economic indicators may point to a weaker quarter, analysts have maintained their earnings estimates since March. This is a significant departure from the typical trend of earnings forecasts being cut by 4% on average, implying that analysts are confident in their forecasts.
“Both our earnings revision ratio and our expectations ratio improved in the second quarter, and Bofa indicators suggest growth is holding up. Conversely, we estimate that exchange rates provided a 100bp headwind to sales, the biggest hit since Q1-23,” strategists said.
According to the BofA team, a key factor to watch this earnings season is the expected shift in growth dynamics. The second quarter is expected to mark the first quarter of earnings growth for the ‘Other 493’ companies in the United States, excluding the Magnificent 7, since the fourth quarter of 2022. In contrast, growth for the Magnificent 7 is expected to slow for the second consecutive quarter and continue. slow down to Q3.
“Growth is expanding and so is the market,” strategists noted.
BofA also emphasizes that while demand is the main driver of profits, inflation is a lagging indicator. The good news is that the expected recovery in demand for the second half of the year is not too optimistic.
Excluding the Magnificent 7, the consensus expects real sales growth of only 1% in the second half. This modest expectation is supported by the end of the destocking cycle, which has been one of the sharpest in history. The ratio of new orders to inventories has improved, indicating that the inventory correction phase is nearing an end.
“Although the expected fourth quarter earnings per share of 14% seems high, more than 60% of the growth will come from the Mag. 7, non-recurring health care expenditures last year, and financial services,” the BofA note adds.
Finally, BofA pointed out that the upcoming earnings season should also bring new insights into the impact of AI investments.
While AI monetization will likely take longer than initially hoped, major tech companies continue to invest aggressively. Consensus expects a 34% increase in hyperscaler capital expenditure (capex) by 2024, totaling approximately $200 billion.
“The key question is whether they will continue to invest aggressively even if monetization is displaced. At this point, there are no signs of investment slowing, and we believe we are in the early stages of an AI investment cycle,” strategists said.
