Setting the stage - A quick lookback at Q1

Despite a rocky December US equity markets ended 2024 up >20% for the second consecutive year. There was quite a bit of optimism with a new administration, a solid economic backdrop and the prospects of AI. That optimism left markets trading with stretched valuations and earnings estimates that called for earnings growth rates that exceeded 15% for the S&P 400, 500 and 600. Markets were priced for perfection leaving them susceptible to volatility.

The year got off to a solid start with the S&P 500 hitting a new all-time high in January, but small and midcap indices underperformed as investors moved up the quality scale as Treasury yields were moving higher. The first real bout of volatility came just after Inauguration Day at the end of January when DeepSeek exploded on the scene, raising questions about the AI trade which had been a driver of market performance for US equities over the last few years. This impacted not only in tech sectors but other areas of the market as well that were levered to the infrastructure and energy buildout. This along with additional stimulus measures helped markets in China and Hong Kong outperform.

A week later tariffs entered the fray with President Trump announcing 25% tariffs on Canada and Mexico along with an additional 10% tariff on goods imported from China. The former was quickly delayed but it was becoming increasingly clear that tariffs were an important piece of the administration’s agenda and that the sequencing would be flipped from Trump 1.0. The administration announced tariffs on steel and aluminum and began discussing sectoral tariffs on autos, semis and pharma as well as reciprocal tariffs. Despite the headlines and declining consumer and business sentiment, the S&P was hitting new all-time highs but there were some cautionary signs beneath the surface with defensive sectors outperforming. US markets were not only underperforming China but also Europe. After years of underperformance the region was helped by the prospect of an end to the Ukraine war. Defense stocks were leading as it was becoming clear the administration was demanding increased defense spending in the region.

The personality of the market really changed in the middle of February as high multiple growth stocks and other crowded positions which fell into the momentum factor, began to come under significant pressure. Some disappointing retail earnings and economic data pointing to a slowdown in economic activity accelerated the weakness as investors began to worry that the policy uncertainty would slow growth. An expected Ukraine mineral deal fell apart on live television which also catalyzed a watershed moment in Europe with Germany announcing it would make constitutional changes to its debt brake exempting military spending from the country’s strict fiscal rules and announcing the creation of a €500 billion infrastructure fund. This sent European defense stocks parabolic and added to outflows from US markets.

As the initial deadline for Canada and Mexico approached the administration set an April 2nd deadline for reciprocal tariffs which was then followed by tariffs on steel and aluminum and autos. US equities were under significant pressure throughout much of March with a 10% peak-to-trough decline in the S&P 500 causing the index to break below its 200d ma for the first time since Q4 of 2023. The administration seemed unphased with Treasury Secretary Bessent saying there was no Trump put. It was also becoming increasingly clear that the strike price for any Fed put would also be much lower as the prospect of tariffs was putting the Fed’s dual mandate at odds with itself leaving the central bank firmly stuck in a wait and see mode.

Last week, Liberation Day (Tariff Day) became Liquidation Day as the reciprocal tariff rates laid out by the administration far exceeded street expectations. Despite a significant amount of de-risking happening within the US market ahead of this catalyst equity markets suffered the largest two-day decline (10.5%) since the pandemic, only rivaled by selloffs during the GFC and 1987 over the last 50 years. The weakness and volatility has not relented this week with the S&P 500 briefly trading down 20% from its peak on Monday. Since the index closed above that threshold whether we have officially triggered a bear market is up for debate, but this would be the second fastest bear market behind only Covid. Global markets have also turned sharply lower wiping out the year’s gains.

Literally hours after the reciprocal tariffs went into effect, President Trump announced a 90-day pause on those tariffs, except for China, changing sentiment dramatically, at least in the near-term. The major equity indexes soared following the news. It's not exactly an all-clear signal though. China's tariff rate was increased to 125% and there are a litany of issues that need to be addressed between the two sides. A pause does not equal a permanent removal. There are still 10% baseline tariffs in effect as well as on aluminum, steel, autos and potentially pharmaceuticals. Trade negotiations could collapse and the tariffs could be reinstated. The topic should remain highly discussed in earnings conference calls.

Inside the Numbers - Data compliments of FactSet Earnings Insight as of April 4, 2025

Q4 Review

2025 Q1 EPS Est. +7.0% YoY

Q1 Revenues Est. 4.2% YoY

Capital return programs - Data compliments of S&P Global

The Big Picture

By the numbers the Q4 earnings season was strong with EPS up 18.2% YoY, the largest increase since Q4 of 2021. Despite the strong quarterly numbers there were multiple companies cutting Q1 guidance and the commentary was cautious which started to push earnings estimates lower. The number of companies issuing negative guidance has exceeded historical averages which has caused Q1 estimates to be cut to 7% from 11.7% at the start of the year. Revenue estimates have also been cut to 4.2% from 5.1%. Despite those revisions the S&P 500 annual earnings estimates have only been cut modestly though this has been much more significant for small and midcap indices. Given the recent developments it feels like these estimates are overly optimistic.

Not surprisingly the big topic on conference calls will be tariffs. There clearly has been some pull forward of demand in anticipation of tariffs (see Chart below). That will have varying impacts depending on the industry. In some cases, this could help to drive beats on both the top and bottom line, but I don’t think that will translate into guidance increases and could negatively impact earnings going forward. On the flip side this could strain working capital as companies build inventories and ultimately impact margins.

Investors are trying to understand how this has impacted the current quarter but more importantly what steps companies are taking to mitigate the impact going forward. Investors will be listening for changes to demand forecasts and will want to better understand what assumptions are currently in guidance. Given the fluidity of the situation, it would not be shocking to see some companies pulling guidance all together. Multinationals seem to be very much in the cross hairs with the implementation of protectionist policies. Within the S&P 500 Info Tech, Communication Services and Materials all have ~50% of their revenue coming from international markets. Last quarter multiple companies highlighted the negative impact of dollar strength, much of that has unwound since the start of the year which could be a tailwind.

Top of mind will be the impact on margins. According to FactSet net profit margins are expected to fall in Q1 to 12.1% from 12.6% last quarter which remains above the 5yr average of 11.7%. If companies are unable to pass along the cost this will clearly have a negative impact. Going forward this could partially be offset by the recent decline in oil prices, which have fallen to levels not seen since 2021. One other variable to keep an eye on is the Red Sea which if the situation improves could also help to lower transportation costs.

Consumer-facing sectors seem to be an area that is most at risk, as sentiment surveys have fallen sharply.

The web traffic data has also been declining for travel, food and restaurant businesses (see the Chart below provided by NYSE-listed similarweb). This is starting to show up in some of the hard data with weakness within retail sales and personal consumption. Retail companies report at the end of the cycle and the commentary from management teams was more cautious. There was also a round of guidance cuts from airlines in early March with the Delta’s management team citing, “the recent reduction in consumer and corporate confidence caused by increased macro uncertainty, driving softness in Domestic demand.”

Financials will dominate the early part of earnings season. Coming into the year expectations were very high given the hope for an improved regulatory environment and an increase in capital markets activity. The volatility has likely helped trading business, but that capital markets cycle has now likely been pushed out. With the recent move lower in yields and increase in uncertainty it will be interesting to see if companies begin to proactively tap credit markets to sure up balance sheets. In general loan demand is expected to remain subdued. Commentary around the state of the consumer, credit quality and the macro environment will be closely watched given their unique vantage point.

Q4 total shareholder returns hit new records driven by a 7.4% increase in buybacks. The sectors represented by the mega-cap tech stocks still make up nearly 50% of the total buybacks. However purchases in those sectors were lower QoQ as mega-cap companies are increasingly committing capital to AI capex. The biggest gains were driven by Healthcare, Consumer Staples and Industrials. With markets consistently hitting new all-time highs companies were getting less bang for their “buyback buck”. The recent weakness has changed that dynamic.

AI capex will continue to be a hot topic. Outside of some noteworthy research around project cancellations, the major players have remained committed to that spending. Investors will be listening closely for quantifiable use of the technology. Morgan Stanley’s Quantitative Research team used the technology to do just that by combing through S&P 500 earnings call transcripts analyze the number of companies that are providing a quantification of AI on their business. The number of companies providing that guidance has increased significantly in recent quarters and as that continues, I think those companies will be rewarded, though it is probably too early to drive a significant shift in the earnings trajectory.

Last week we discussed the concept of B.T. and A.T (before and after tariffs) as it relates to economic data. Q1 earnings clearly fall into that B.T. category as well. Even if the numbers turn out to be better than feared that won’t likely carry very much weight. Given the recent historic selloff valuations are much less stretched than at the start of the year. However, it does seem that the “E” part of the equation is at risk. It seems unlikely that management teams will be able to provide much certainty around guidance this quarter but hopefully they will convey some confidence that their war room preparation has left them ready to adapt no matter the outcome.