Corporate profits drive equity performance
Understanding the drivers behind profitability growth should allow better forecasting and aid regional equity allocation
Stellar performance of US corporates
It seems like the new norm: in recent quarters, US corporate profits have exceeded expectations often enough to render such terminology almost meaningless. Reports for the April to June period have been no exception to the trend, with second-quarter earnings thoroughly surpassing analysts’ predictions. What is unusual, however, is that expectations had been set very high before the season began. It is very rare for analysts to revise forecasts higher in the short period before companies release their earnings. Typically, the opposite is true – analysts tend to lower the bar for companies allowing them to ‘beat [the forecast] and raise [the guidance]’. This was not the case this time – the bar was set high and companies exceeded demanding forecasts.
The wider results speak for themselves. For the S&P 500 Index, second-quarter earnings year-on-year growth is 24.4%, only a minor deceleration from the first quarter’s blowout rate of 26.5%. Not only have 79% of the companies releasing earnings this quarter surprised to the upside, but they have done so by a wide margin. On average, ‘earnings-per-share (EPS) beats’ have been by over 5%.
Sceptics may say that stellar earnings have been driven solely by President Trump’s tax reform, but there is much more to the story. Certainly, lower corporate taxes have made a significant contribution, but underlying organic growth was impressively strong and spread widely across all sectors, running at about 16% year-on-year.
This figure is testament to strength in the US domestic economy. Higher domestic demand is evidenced in solid revenue growth of 9.3% year-on-year over the quarter. The breadth of this improvement has been very impressive, with every sector of the S&P 500 Index registering both earnings and top-line growth. Healthy US-based demand was best demonstrated by the rise in spending by consumers - for example, Wal-Mart, the largest retailer in the US, recently reported its best sales growth in over a decade.
More broadly, US earnings strength has been one of the reasons cited for the divergence (outperformance) of US equities versus other parts of the world. Overall, investors have reacted favourably, reaffirming their confidence in US holdings rather than selling them on the good news. This contrasts to the first-quarter season, when many strong releases were met with scepticism and shareholders fearing that peak earnings would fade quickly.
As always, however, forward guidance is extremely important. The outlook is still robust, but deceleration is expected without the one-off tax boost experienced this year. Barring unpredictable geopolitical events, we think that the 2019 bar for US earnings growth seems set at a reasonable level (10%), although it sits above the long-term average of about 6% annual EPS growth for the S&P 500 Index.
Where next for US profits?
US earnings now lie well above their long-term trend line. Corporate profitability is undoubtedly elevated and margins are high. While upward pressures on costs typically start emerging as economic cycles mature, financing and unit labour costs are still low by historical standards, meaning US companies can enjoy the sweet spot between strong revenues and contained cost bases. There are, however, early warning signs; input costs have been rising and wage competition for certain industries facing worker shortages is also intensifying. For example, investors in the Cheesecake Factory were left with a bitter taste in their mouths when the stock tumbled on labour-cost pressures.
While recent guidance from US companies did not provide much information on the effects of potential trade wars, foreign exchange moves and the implications of a stronger dollar were hot topics. Currency appreciation will be a headwind to US profits, but is likely to provide much-needed respite to corporate profits earned in UK and European operations.
Can European profits catch up?
So far, the picture on the other side of the Atlantic has been less euphoric than in the US. According to data from Thomson Reuters, less than half of companies in the STOXX 600 Index exceeded earnings expectations for the second quarter. The revenue figure was a bright spot; 60% of European companies beat sales forecasts in a move away from recent trends. To a large extent, stronger sales were attributed to the decline in the euro over the period. European indices contain many exporters, so a weaker euro means that products from these companies become more internationally competitive, making their foreign earnings more valuable.
But there are some disadvantages to a weaker euro, too, one being an adverse effect on internationally traded input costs. Credit Suisse estimates that, for European companies, the euro-denominated oil price was up 37% year-on-year on average in the second quarter. This added to cost pressures for certain sectors, perhaps providing an explanation of why better revenues did not quite translate to positive earnings surprises. Wage growth is still relatively contained in Europe, but such costs are slowly creeping up. Investors will be looking for ways in which companies can pass on higher costs to customers.
A crucial variable in determining Europe’s corporate profitability outlook is global demand for goods and services. Requirements may be affected not only by protectionism emanating from Washington, but also by the general uncertainty that the threat of such policies creates. An escalating trade war may have a disproportionate effect on internationally exposed European companies compared to their US-based counterparts. This, then, is the great unknown, a topic that will undoubtedly stay at the forefront of both investors’ and CEOs’ minds over the coming months.
View the full Global Outlook publication below:
- Strategic Asset Allocation Outlook
- Corporate profits drive equity performance
- Value in the global energy sector
- From Smart Beta to Smarter Beta
- Improving returns by investing in concession infrastructure funds
- Gender Diversity: an economic and strategic imperative
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