- Manufacturing activity has softened on the back of unresolved trade tensions; Federal Reserve easing now seems likely into the end of the year.
- The current earnings season has been mixed; lower energy prices and a stronger dollar are headwinds, but health care sector M&A is providing an offset.
- Buybacks are supporting 2Q earnings; share repurchases look set to continue, but will only offset so much weakness in margins and revenues.
- 2020 consensus earnings estimates are too high at 11% and will need to decline; as this occurs, focus on cyclical value.
Trade, profits and the consumer
Trade tensions have been the main driver of weakness in the manufacturing sector this year. While this weakness has been offset at a global level by the relative resilience of the services sector, a disappointing May jobs report and slide in inflation expectations that began in September 2018 has led many, including the Federal Reserve (Fed), to worry that the end of the expansion might be closer than originally thought. As a result, we have seen a dovish pivot by the U.S. central bank, with an interest rate cut now likely at the end of this month. Although such action will fail to boost growth or inflation, it may provide a lift to inflation expectations, which seems to be the Fed’s underlying goal.
The risk remains, however, that softer nominal economic growth will continue to drag on corporate profits. While many companies have already taken steps to offset this weakness by slashing CAPEX and investment spending, at the current juncture, there isn’t much else on the investment side that can be cut. The wage growth seen over the past 24 months should begin to impact profit margins, suggesting further weakness in earnings will be met with labor force reduction. In an economy like the U.S. that is 70% consumption, labor market weakness will have a significant impact on growth, making the outlook for profits key to successfully gauging the longevity of this cycle.
Profit margins could come under pressure due to rising wage costs
Net income margins, %, y/y % change in average hourly earnings for production and nonsupervisory employees