US economic growth data has surprised the consensus to the upside so far this year, continuing to expand at around trend pace and defying widespread predictions for a mid-year slump into recession.

Earnings, following the broad economy, have also surprised to the upside, and revisions have edged back into positive territory after three quarters of declines.

77% of S&P 500 companies delivered positive earnings surprises across the Q1 earnings season, which is above the 1-year and long-term averages of 73.5% and 66.3%, respectively. On a year-on-year (YoY) basis, Q1 earnings fell by 0.2% against initial expectations of a 5% decline. An improving trend was evident across all regions (excluding Australia), which saw revenues and earnings come in significantly ahead of expectations.

Encouragingly, after declining for 9 consecutive months, 12-month forward earnings estimates are now rising in the US. There is a fairly consistent relationship between earnings revisions and economic surprise indices: when the economic data surprise to the upside, analysts typically revise up their earnings estimates.

While analysts expect earnings for the S&P 500 to decline in Q2 2023, they also project earnings growth to return in the second half of 2023. Profit margins have also returned to 2019 levels, suggesting the worst of the margin squeeze may be over as companies get cost bases back under control.

On balance, outlook statements by management continue to paint a relatively benign environment of solid yet slowing demand, albeit with a cautious outlook highlighting forecast risk in an uncertain environment.

US Q2 reporting season - stretching from mid-July to mid-August - will once again be closely watched. Good cost discipline and prudent capital management should remain a focus, while artificial intelligence (AI) excitement will undoubtedly continue, with many companies likely commenting on the potential positive impact it can have on their productivity and/or revenue line.

Entering 2023, equity positioning was quite cautious, and many investors have been caught chasing gains as stocks have delivered impressive returns year to date, driven in part by better-than-feared economic and earnings outcomes.

The top contributors to positive earnings revisions for the S&P 500 have all seen significant price increases since the start of the year. The Communication Services and Information Technology sectors have seen the largest price increases of all eleven sectors, with gains of over 30%.

Our Global Opportunities List has matched this year to date performance (average return across members), and 3 month EPS revisions have been positive for 90% of members (Figure 6).

Technology mega caps have been important in driving the long-lived US earnings upswing, which, in turn, has been pivotal to the outperformance of the US stock market over the past 10 years. Although re-rating has made a sizeable contribution, it is superior earnings growth that has driven the largest share of US performance in absolute and relative terms.

The mega caps are being propped up by multiple tailwinds including their tilt towards defensive growth, the AI revolution, and an anticipation of a Fed pivot towards rate cuts later this year. While their earnings have endured a degree of volatility in recent years, the group is on its way to reaching $315 billion in combined profits for 2023. That is nearly double what they delivered in 2019 before the pandemic, a long-term rate of growth that goes a long way to justifying their resurgence.

We believe the proven capability of US corporations to generate superior earnings growth will prevail over the medium term. Although it may not be as strong as the previous decade, which benefited from generous corporate tax cuts, we remain optimistic that US corporations’ exceptional quality and positioning will enable them to maintain their track record of superior earnings growth over coming years

European economic growth has proved more resilient than expected. Energy price dynamics are supportive and corporate earnings momentum has turned positive. Since February, there has been a 1.3% upgrade in 12-month forward earnings within the market. This has been one of the bigger surprises given how depressed investor sentiment was following Russia’s invasion of Ukraine.

High oil prices benefited European energy companies in 2021, and the change in interest rates from negative to positive has had an outsized impact on corporate profit expectations for banks in 2023. Most of the expected EPS growth in 2023 (versus 2022) is expected to come from the financial sector. Similarly, the recent increase in European earnings estimates over the quarter has been primarily driven by financials.

This upgrade cycle indeed reflects the better-than-expected outcomes in Europe. However, as we enter the second half of this year, we approach the situation with a degree of caution. Inflation in the region has proven persistent, and there are signs of growth faltering. We anticipate these factors to weigh on earnings expectations in the short term.

In summary, while there may be further slowing in US and global macro conditions, we believe that a hard landing for earnings – characterised by a significant contraction - can be averted. Gains from equities (our base case) are still possible in a soft earnings year, provided downgrades are relatively mild and the monetary policy cycle becomes more favourable. Corporates will likely have to negotiate some further slowing in US and global macro conditions, so the downgrade cycle will likely re-emerge in coming months.

Guidance from the upcoming US Q2 reporting season will be closely watched. We note Australia’s earnings momentum has recently been inferior to global equities, despite the economy not yet decelerating significantly. In a downgrade cycle, resilience is key. A strategic allocation to quality, growth, and defensive stocks becomes increasingly prudent in a slowing economy, still characterised by heightened uncertainty.