3Q18 US Earnings: The risks begin to crystallizeContributors David Lebovitz, Tyler Voigt
- After a relatively quiet summer, volatility spiked in October as investors worried about rising rates, peak economic and earnings growth and geopolitical tensions.
- The earnings season is off to another strong start, with health care, technology, and energy companies continuing to post impressive numbers. However, short- and long-term risks are beginning to materialize.
- While most companies have provided only anecdotal evidence, our work suggests that tariffs could hit 2019 earnings by $5-$7 per share.
- Cyclical value sectors that provide income and a more balanced total return can help enhance returns and dampen volatility. This can be achieved through a blend of both active and passive management.
Markets on a rollercoaster
Volatility has made a triumphant return, with the S&P 500 falling -7.2% since the end of September. This has been driven by a sharp move in interest rates, as the 10 year U.S. Treasury yield has risen 8 bps over this same time period, along with concerns about peak economic and profit growth. While we maintain our view that in the long-run the level of rates is what matters for equity performance, in the short-term, pace and magnitude matter much more. The past few weeks have served as a reminder of that.
With the 3Q18 earnings season underway, many investors are expecting that a string of strong earnings reports may alleviate some of the market’s recent indigestion. While we believe that the current earnings season may provide a bit of relief, it will also bring a variety of risks into focus. To start, those sectors which derive a greater share of their revenues from outside the U.S. have begun to feel the impact of a U.S. dollar that has strengthened over the course of this year. Looking ahead to 2019, earnings growth looks set to decelerate as profit margins come under pressure from rising rates and higher wages, and the potential for an escalation in trade tensions to further undermine profitability remains a risk.
Earnings have acted as a safety net for the stock market this year, providing support when equities have begun to wobble. However, this safety net is beginning to fray, suggesting the market may be more exposed to economic and political risks in the year to come. However, we still see room for equities to climb higher – since 1945, the S&P 500 has risen by an average of 23% during the final twelve months of a bull market. It may be challenging to generate returns of this magnitude as rising rates will limit multiple expansion, but barring significant multiple contraction, mid-single digit returns still seem like a reasonable expectation for the year ahead.
Don’t forget about the dollar
This earnings season should continue to reflect many of the themes that have been present in prior quarters. With 55.8% of companies reporting, our current estimate for S&P 500 3Q18 profits stands at $40.58, which implies a 29.5% growth rate from a year earlier. Of the companies that have reported, 80% are beating earnings estimates, but only 46% are beating sales estimates; while this downshift in sales beats is notable, it is actually in line with the average seen since 2012. Finally, profit margins appear to have risen to 12.1% in 3Q18 - this represents a 2.0%-pt increase from a year ago, and the highest level of profit margins since 1990.
In general, companies continue to benefit from lower tax rates, above-trend economic growth, a moderate rise in wages and manageable interest rates. At the sector level, results from energy, health care, and technology companies are expected to be particularly good. Energy companies are benefitting from oil prices which are 45.0% higher than a year ago, and despite an uptick in investment spending over the past few quarters, have shown restraint when it comes to production. However, with key oil producers currently standing at the epicenter of a slew of geopolitical risks, it will be important to keep an eye on how oil prices respond.
EXHIBIT 1: EARNINGS BEATS HAVE REMAINED ELEVATED WHILE REVENUE BEATS HAVE COME BACK TO AVERAGE
% of S&P 500 companies beating earnings and revenue estimates
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