Politics vs. fundamentals
The stock market is caught in a tug of war between politics and fundamentals. On the one hand, escalating trade tensions and the potential for additional tariffs suggest caution may be warranted; on the other, robust economic and profit growth support risk assets continuing to climb higher. So far the fundamental forces seem to be winning-as evidenced by the S&P 500’s positive year-to-date return-but the recent softening in confidence indicators, albeit from elevated levels, will be worth monitoring.
Against this turbulent policy backdrop, the 2Q18 earnings season is continuing the streak of healthy profit growth that began nearly two years ago. With approximately 62.6% of companies reporting, 84% are beating earnings estimates and 60% are beating sales estimates. Looking at a combination of reported earnings and analyst estimates, we forecast 2Q18 S&P 500 profits grew by 28% from a year prior.
As shown in the Exhibit 1, many of the themes that dominated earnings announcements in the first quarter have continued-a significant benefit to profits from tax reform, higher oil prices supporting energy sector earnings, and a weaker U.S. dollar benefitting those companies with healthy revenue generation outside the United States. In other words, the stars aligned once again for earnings in the second quarter. We estimate that tax reform is responsible for about 7%-pts. of the earnings growth seen in 2Q, while a weaker U.S. dollar and higher oil prices have contributed 3%-pts. and 1%-pts. respectively. Furthermore, profit margins look to have hit an alltime high of 11.8%, as low rates, still-weak wage growth, and lower taxes all provide a boost to profits.
EXHIBIT 1: 2Q18 DRIVERS OF EARNINGS GROWTH
Contribution to year-over-year % change
Source: Compustat, Federal Reserve System, NYMEX, Standard & Poor's, FactSet, J.P. Morgan Asset Management. Revenue and earnings growth estimates are based on J.P. Morgan Asset Management model and calculated using actual earnings and revenue for 62.6% of S&P 500 market cap and earnings and revenue estimates for the remaining companies. Oil and U.S. dollar contribution is based on regression analysis. Data are as of 7/26/2018.
Cyclicals lead the charge
The cyclical sectors are having another solid earnings season. Financials are benefitting from tax reform, higher rates, stable lending, and strong initial public offering and merger and acquisition (M&A) activity, but data on capital markets revenues is mixed. Furthermore, because some banks fumbled parts of the Federal Reserve’s June stress test, their capital return plans have been put on hold. That said, a number of financial institutions have mentioned that in addition to any capital return plans, investment spending is set to accelerate as firms upgrade communications equipment and other technology.
The more globally-exposed sectors-technology, industrials and materials-are also seeing another solid quarter of profit growth. These sectors in aggregate have benefitted from the -1.8% year-over-year decline in the U.S. dollar1, but a weaker start to the year for the global economy could be an offsetting force. That said, early reports from the tech sector show that margins remain robust and buyback activity remains solid, providing an extra boost to the bottom line. Industrial companies continue to feel some pain from higher input prices, but an uptick in U.S. economic activity has boosted revenue growth and helped offset some of the downward pressure on margins.
The energy sector continues to recover, and earnings seem to have more than doubled in the second quarter from a year prior. The average price of WTI oil was up over 40% in 2Q2, which coupled with an uptick in shale drilling activity, has boosted energy company profitability. In fact, daily U.S. oil production is up 15.4% y/y, leading some energy companies to experience their highest profit margins in years. Additionally, after pulling back on capital spending in the aftermath of sharply lower oil prices in 2014-2016, those firms that are investing are using internal funding to do so, helping to keep leverage in check.
1Based on the year-over-year change in the average quarterly value of the Federal Reserve’s nominal broad effective exchange rate.
2 Based on the year-over-year change in the average quarterly WTI oil price.
How to spend all that cash?
After paying taxes on foreign earnings at the end of last year, the beginning of 2018 has seen the first signs of repatriation. One obstacle to calculating how much cash has been brought back to the U.S. is that most companies don’t report their cash balances by region. That said, the balance of payments data shed some light on this issue. The return on equity (or earnings) of foreign affiliates is typically comprised of cash that is repatriated to the U.S. parent company in the form of dividends and a portion that is reinvested in the foreign affiliate. When the value of this dividend exceeds current period earnings-as it did in the first quarter-this indicates repatriation3. Based on our calculations, U.S. corporations repatriated about USD 200 billion in 1Q18. Importantly, it seems that most of this cash is held in U.S. dollars, making the impact on the currency somewhat negligible as this money comes back to the United States.
This backdrop of robust profitability, coupled with the continued repatriation of foreign profits, begs the question of how these funds will be used. While there are early signs that some of this cash is being strategically deployed in the form of investment spending, we continue to expect that the majority of these funds will be used for buybacks, dividends, and M&A.
Historically, there has been a lagged relationship between profit growth and capital spending-as profit growth accelerates, companies become more confident in the outlook for demand, and subsequently increase investment spending in an effort to meet this expected demand. While profit growth has been quite strong, suggesting that a pick-up in capital spending may be imminent, there are offsetting political forces at work. The Federal Reserve's Beige Book-which gathers anecdotal information about business conditions across the U.S.-saw tariffs or trade policy mentioned 51 times in the July edition, up from only three mentions of trade-related uncertainty in March when tariffs were first announced4. As such, despite certain instances where investment spending has picked up, it seems reasonable to expect that trade tensions may prevent the acceleration in capital expenditure that some expected at the beginning of this year.
Furthermore, data on buybacks and M&A activity suggest that companies continue to focus on these areas, rather than investment spending, when it comes to deploying excess cash. Announced buybacks in 2018 are well above the average seen over the course of this cycle (Exhibit 2), and if M&A activity maintains its current pace through the end of 2018, it will hit its highest level in over fifteen years (Exhibit 3). Any softening in the trade situation could lead investment spending to accelerate, but with the nominal growth outlook still a bit uncertain, this feels like it would be the exception, rather than the rule.
3Bureau of Economic Analysis, June 20, 2018.
4Canally, John. U.S. Investment Strategy: Powell Tells All. BCA Research. July 23, 2018.
EXHIBIT 2: BENEFITS FROM TAX REFORM HAVE PROVIDED A SIGNIFICANT BOOST TO BUYBACKS
S&P 500 announced buybacks, USD bn
Source: Bloomberg, Standard & Poor's, J.P. Morgan Asset Management. Based on company announcements. Data are as of 7/26/2018.
EXHIBIT 3: M&A IS ALSO POISED TO HAVE A RECORD YEAR
Announced M&A transactions globally, USD bn
Source: Bloomberg, J.P. Morgan Asset Management. *2018 estimate is based on current pace of M&A through 7/26/2018. Data are as of 7/26/2018.
Investment implications: Should I worry about the yield curve?
Over time, stock prices follow earnings, and over the past eighteen months, earnings have been responsible for nearly all of the price appreciation we have seen in the S&P 500. Equities should be able to continue their upward ascent as long as corporate profits are growing, but with the pace of earnings expected to slow next year alongside a continued rise in rates, the return environment will become more challenging. Furthermore, the slope of the yield curve (as measured by the difference between 10-year U.S. Treasury yields and 2-year U.S. Treasury yields) is near its flattest level this cycle, leading investors to wonder whether a recession and end to this bull market may be lurking around the corner.
Historically, an inverted yield curve has done a fairly good job of signaling recession. That said, massive central bank intervention since the financial crisis may have distorted the message coming from this indicator. Furthermore, inversion is the recession signal, rather that flattening, and once the yield curve does invert, it has been anywhere between six and eighteen months before the economy finds itself in recession. Finally, as shown in Exhibit 4, the equity market tends to peak after the curve has inverted, not before.
EXHIBIT 4: THE S&P 500 USUALLY PEAKS ONLY AFTER THE YIELD CURVE INVERTS
U.S. 10-yr. yield minus U.S. 2-yr. yield, %
Source: Tullett Prebon, Federal Reserve System, Standard & Poor's, FactSet, J.P. Morgan Asset Management. The yield curve is measured by the difference between the 10-yr. U.S. treasury yield and 2-yr. U.S. treasury yield. S&P peak dates are 2/13/1980, 11/28/1980, 7/16/1990, 3/24/2000, 10/9/2007.Data are as of 7/26/2018
We acknowledge that the U.S. economy is late cycle, that the curve is flattening, and that politics are contributing to uncertainty. However, the U.S. economy looks set to continue growing at a 3% pace through the middle of next year, before decelerating in the back half of 2019 as fiscal stimulus fades and supply-side constraints take hold. This will impact the trajectory of earnings growth, and investors will need to adjust sector allocations accordingly. That said, the near-term environment of solid economic expansion and rising interest rates should provide support for equities broadly, and the more cyclical parts of the value index in particular. Trade fears and a stronger U.S. dollar have led investors to embrace small caps over large caps due to their more domestic orientation, but these companies could come under pressure if the U.S. dollar weakens in the back half of this year. At the end of the day, the tug of war between fundamentals and politics has not yet seen a clear winner; as a result, investors should be prepared for a bumpy ascent.