Volatility has returned, but healthy earnings growth should prevent minor pullbacks from becoming more severe and support a continued rise in U.S. equity markets against a backdrop of higher interest rates.
The 4Q17 earnings season is off to a strong start, with the number of companies beating earnings and revenue expectations near all-time highs; financials, energy and technology were key drivers for profits in 4Q.
The Tax Cut and Jobs Act (TCJA) has inundated 4Q17 earnings with one-time charges and benefits related to deferred taxes and cash held abroad, but these charges should be viewed as short-term pain in exchange for benefits that will be recognized over the long-term.
Certain sectors and styles stand to benefit from tax reform more than others, suggesting an active approach to investing is warranted in the current environment.
Safety in earnings
The U.S. equity market ended 2017 on a high note, and this momentum has carried over into 2018. Investors have embraced an outlook characterized by healthy global growth, a new U.S. tax bill, still-low inflation and a gradual normalization of monetary policy, pushing risk assets higher in the process. We expect a more volatile market environment in 2018, and would not be surprised by a 10% correction at some point this year. However, there is good reason to believe that it would only be a correction, and not the beginning of a bear market.
The primary catalyst for such a sell-off would likely be a sharp rise in interest rates or interest rate expectations, as this would lead the risk-adjusted returns available in fixed income markets to look increasingly attractive relative to equities. Returns in 2017 were driven by nearly equal contributions from earnings growth and multiple expansion, with the improvement in sentiment leading the S&P 500 forward P/E ratio to levels not seen since 2002. While this suggests that valuations may be at risk, with the solid earnings growth seen in 2017 expected to continue during the coming year, profits should act as a safety net and catch the market if it begins to fall.
Earnings and taxes
The 4Q17 earnings season is off to a good start. With 66% of S&P 500 market cap reported, 77% of companies have beaten earnings estimates, and an impressive 70% of companies have beaten revenue estimates, the highest revenue beat rate since the first quarter of 2010 (Exhibit 1). Based on reported earnings and analyst estimates, operating earnings are estimated to have grown by about 19% over the past year, as profit margins sit near all-time highs and revenue growth has remained solid.
Exhibit 1: Earnings and revenue beats are at or near all-time highs
% of S&P 500 companies beating revenue and EPS estimates
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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.