3Q Earnings Update: Earnings will set you free - J.P. Morgan Asset Management
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3Q Earnings Update: Earnings will set you free

Contributor David Lebovitz

The third quarter saw another instance of strong performance for both U.S. and global equity markets, with the MSCI All Country World Index rising by 5.3% in U.S. dollar terms and the S&P 500 rising by 4.5%. This healthy performance represents a continuation of the trend seen in equity market seen so far this year – healthy global earnings growth is providing fundamental support for stocks to push higher, and a weaker dollar combined with gradual multiple expansion in markets outside the U.S. have boosted international returns. What has been particularly impressive is the breadth of the current earnings expansion; as shown in the chart below, we are seeing above average earnings growth across a broad spectrum of countries and sectors, a far cry from just a few years ago when earnings growth was narrow and muted.

Strong earnings growth is widespread across countries and sectors

EXHIBIT 1: % OF COUNTRIES AND SECTORS WITH ABOVE AVERAGE EARNINGS GROWTH

Source: MSCI, Standard & Poor's, FactSet, J.P. Morgan Asset Management.
Earnings growth based on a 6 month percent change since 6/30/1999. Earnings is based on the last 12 months earnings as reported by companies and is provided by FactSet Market Aggregates. The 30 countries included are Argentina, South Africa, Japan, United Kingdom, Canada, France, Germany, Italy, Australia, Austria, Brazil, China, Colombia, Denmark, Finland, Hong Kong, India, Malaysia, Mexico, Netherlands, New Zealand, Peru, Philippines, Portugal, Korea, Spain, Taiwan, Thailand, Turkey, United States. Sector earnings are based on the 10 GICS sectors (excluding real estate) in the MSCI AC World index. Data has been adjusted for outliers with a +/-100% 6 month percent change.
Data are as of 10/18/2017.

Despite this healthy earnings backdrop, however, investors continue to question the sustainability of recent market gains given the backdrop of historically low volatility. As we have mentioned in  prior publications   , we believe that today's low level of volatility can be explained by a number of different macro trends, and is not necessarily a signal that correction is imminent. As long as earnings continue to rise, we are comfortable being long equities.

Low expectations

The 3Q17 earnings season is underway, and expectations are that the pace of earnings growth began to slow last quarter. With 17.5% of S&P 500 market cap reporting, 80% of companies have beaten earnings estimates, 58% have beaten revenue estimates, and we forecast that operating earnings grew by 9.3% over the past year. However, it is important to note the sharp downward revisions that occurred at the end of the third quarter, as analysts factored in the impact of hurricanes Harvey and Irma. These revisions may have led earnings estimates to become a bit too pessimistic. S&P 500 earnings surprises have averaged 4.9% over the past 5 years, so if history is any guide, 3Q earnings growth could end up being stronger than many analysts expect.

Companies should beat earnings expectations despite drastic downward revisions

EXHIBIT 2: S&P 500 Y/Y EARNINGS GROWTH, ESTIMATES AND SURPRISES

Source: IBES, Standard & Poor's FactSet, J.P. Morgan Asset Management. Earnings estimates are based on estimates the day before a company reports earnings. Estimates are aggregated on a bottoms up basis. Earnings surprise is the difference between analysts expected earnings growth and actual earnings growth.
Data are as of 10/18/2017.

The energy sector looks set to be the largest contribution to earnings, with analysts estimating that earnings rose 329% from a year prior. Earnings growth is expected to have been driven by a 7.1% increase in the average price of WTI, as well as favorable base effects. However, as highlighted last quarter, there continues to be a divergence between upstream and downstream company profitability. The chart below shows that expectations are for another quarter of positive earnings among downstream companies, while upstream company profits look set to keep dragging on overall sector performance.

Downstream companies have recovered nicely, while upstream companies are set to stabilize

EXHIBIT 3: CONTRIBUTION TO S&P 500 EARNINGS BY ENERGY SECTORS

Source: Standard & Poor's, FactSet, J.P. Morgan Asset Management
Earnings are based on company 10Q filings and adhere to GAAP reporting standards.*3Q17 is based on analysts estimates. Companies are segmented based on where the majority of their revenue is derived.
Data are as of 10/18/2017.

We expect this industry level divergence to gradually close on the back of a continued decline in drilling breakeven costs and the prospect of a further reduction in OPEC production. Thus, it seems reasonable to expect upstream companies will return to profitability in the coming quarters. Meanwhile, the downstream sector looks solid, particularly as refiner capacity utilization sits at 95%, its highest level since June 2005. While some of this is due to the impact of the late summer hurricanes, the energy sector is gradually healing.

Those sectors with the largest international revenue exposure are also expected to contribute meaningfully to earnings growth this quarter. Energy is included in this group, along with technology, materials, and industrials. Solid global economic growth and a notable depreciation in the U.S. dollar have provided a tailwind for globally exposed sectors, with technology earnings in particular benefitting from a refresh in the global smartphone cycle and healthy economic activity in emerging markets. Furthermore, with the IMF projecting a further acceleration in global economic growth next year, it seems reasonable to expect this trend will continue.

Despite positive contributions from energy and the more globally-exposed sectors, financials are expected to exert a modest drag on headline earnings growth for the first time in 5 quarters. Part of this stems from lackluster expectations for large financial services firm profits. These institutions saw a further deceleration in loan growth, which along with subdued trading activity, overwhelmed any positive contribution from higher interest rates and expense management.

The second area of weakness in the financial sector broadly was concentrated in the insurance industry, as hurricanes Harvey and Irma wreaked havoc on the southern coast of the United States. Current estimates point to the cost of Hurricane Harvey as being between $10 and $25 billion and the cost of Irma being between $20 and $40 billion. However, because homeowners’ policies typically exclude flood coverage, estimates are that over 70% of flood losses are uninsured. That said, the impact on insurance company profits looks set to be substantial, and has accounted for a 12.4 percentage point decline in expected year-over-year financial sector profit grow over the past few weeks.

Investment implications

Healthy global growth should continue to translate into solid profit growth, but given that the U.S. business cycle looks to be more mature than is the case in other parts of the world, what are some of the risks? Margin expansion has been a significant driver of earnings growth over the past few quarters, but as labor markets continue to tighten, rising wages could begin to put downward pressure on margins going forward.

Rising wages may begin eating into profit margin

EXHIBIT 4: LABOR SHARE OF INCOME AND PROFIT MARGINS

Source: BEA, FactSet, J.P. Morgan Asset Management.
Labor share calculated as employee compensation as a percentage of nominal GDP. Profit margins are after-tax corporate profits with inventory & valuation adjustment as a percentage of nominal GDP
Data are as of 10/18/2017.

Another risk to margins stems from rising interest rates; while Baa corporate bond spreads tightened last quarter on the back of rising Treasury yields, it is unclear how much further spreads can compress. Eventually, rising Treasury yields will put upward pressure on spreads, thereby raising interest costs and creating another potential source of downward pressure on margins.

As margins come under pressure, companies need to invest in themselves for output growth to continue. The easiest way to grow output is to boost productivity, as this makes the pie bigger. While we expect any rise in rates or wages to be gradual, the risk is that productivity remains muted and margins begin to erode, putting downward pressure on corporate profits. While it is unlikely this will be an issue in the fourth quarter, it should be on every investor’s radar entering next year, as wage growth and corporate bond yields have explained over 50% of the variation in margins since 1990.

So where does that leave us? We expect that rates will gradually rise into the end of the year, the U.S. dollar will remain contained, and that some sort of tax cut will become a reality in 1Q18. From a style and size perspective, this environment should favor small cap over large cap and value over growth.

Digging a bit deeper, we continue to maintain a preference for the more cyclical sectors over the defensives ones. Part of this thesis has to do with our belief that rates will gradually rise from their current levels, as well as that healthy economic activity abroad will support solid U.S. economic growth in the coming quarters. Specifically, we see upside in financials, industrials, materials and energy, but the key to successful investing continues to be to follow the earnings.

Important information

Please be aware that this material is for information purposes only. Any forecasts, figures, opinions, statements of financial market trends or investment techniques and strategies expressed are, unless otherwise stated, J.P. Morgan Asset Management’s own at the date of this document. They are considered to be reliable at the time of writing, may not necessarily be all-inclusive and are not guaranteed as to accuracy. They may be subject to change without reference or notification to you. JPMorgan Asset Management Marketing Limited accepts no legal responsibility or liability for any matter or opinion expressed in this material.

The value of investments and the income from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a guide to the future.