Second quarter earnings season was outstanding by many measures. The numbers were strong even without the boost from the new tax law, with guidance generally positive despite tariffs and trade policy uncertainty. We expected another strong earnings season for the second quarter. Growth was impressive, with S&P 500 Index earnings growing 25% year over year, nearly matching the 26% growth rate from the quarter before. Even when excluding the impact of the new tax law (estimated at 6-7%), earnings growth came in at 18-19%, which is still outstanding. A pickup in economic growth, strong manufacturing activity, tax cuts, and a weaker U.S. dollar versus the year ago quarter were the biggest contributors to earnings gains. However, the technology sector was by far the biggest contributor to S&P 500 earnings growth, accounting for more than 25% (specifically, 6.7% out of the 25% came from technology).
Other highlights:
• S&P 500 earnings have increased at a double-digit clip five out of the past six quarters.
• Based on Thomson Reuters data, earnings have exceeded consensus expectations for 37 consecutive quarters.
• Again, based on Thomson Reuters data, at 80% the percentage of companies beating earnings estimates is the highest on record going back to 1994.
• The magnitude of the earnings surprise, at 4%, was slightly above the post 1994 average.
• Revenue grew 9.4% year over year, the fastest pace since 2011. Revenue’s upside surprise of 1.4% is one of the largest of the current economic expansion and bull market.
• Estimates for the first four quarters rose during reporting season for the second straight quarter, a rare positive development and particularly impressive late in the business cycle amid trade/ tariff concerns. Some have spoken about a peak in the earnings cycle. Even if earnings growth slows markedly from the current pace, we still believe the earnings and economic outlooks are favorable enough to keep this bull market going through 2019 and potentially longer.
There are four takeaways that emerged from the strong second quarter earnings season:
• Trade issues have had a limited impact (so far). Several companies highlighted the uncertainty surrounding trade policy during reporting season, particularly industrial companies. However, the overriding message was that the impact has been limited. Companies discussed potential supply chain shifts, the pass-through of higher costs to consumers, and even some “prebuying” to get products before tariffs were implemented. Goldman Sachs estimates that a 10% tariff on all Chines imports could reduce 2019 earnings per share for the S&P 500 by about 3%, suggesting this is a meaningful risk, but one that is unlikely to halt earnings growth next year.
• Margin expansion opportunities are probably limited. Building wage pressures get the most attention because labor is the biggest cost component of S&P companies. However, logistics costs, commodity costs, and borrowing costs are also rising, suggesting that profit margins may level off in late 2018. That would leave revenue growth (including passing tariff driven cost increases along to customers in the form of higher prices), more share buybacks and efficiency improvements to drive gains in earnings per share. The recent uptick in capital investment could lift productivity and support margins. There may be still be some profit impairment from the energy sector downturn in 2015-2016 to recover but based on where we are in the business cycle, upside could be limited.
• Rising estimates reflect generally upbeat guidance. During reporting season, S&P 500 earnings per share estimates rose 0.5% (like what happened in the first quarter). Historically, estimates fall 2-3% during this period, suggesting guidance has been unusually positive. Some filtering through of tax cuts is likely at play here, but organic drivers of earnings all look good, notably business investment and manufacturing trends. Economic growth looks set to continue at a solid pace into 2019 based on our leading economic indicators, and modestly higher inflation enables some pricing power that may boost future revenue growth. However, 2019 consensus S&P 500 earnings growth estimates of 10% may be a bit too high given the likelihood of a more challenging margin environment.
Corporate America is deserving superlatives. Second quarter earnings season was outstanding on a variety of measures, including growth rates, beat rates, and upside surprises on both the top and bottom lines. Results more than support our earnings growth forecasts for 2018 and are particularly impressive given the implementation of tariffs and building wage pressures. Bolstered by second quarter results, our 2018 S&P 500 earnings forecast of $155 per share, representing growth of 17%, may prove to conservative. The impact of tax reform is still cycling through. We expect continued strong earnings growth to drive further upside in the S&P 500 over the balance of 2018. Even as the S&P 500 nears the low end of our year end target of 2900, we are not recommending investors sell stocks here. We expect the bull market to continue well into 2019 and potentially beyond, despite now being the longest ever. But with little progress on China trade negotiations, midterm elections looming, and the index already up more than 8% year to date, any additional gains may come with higher volatility. We suggest keeping equity allocations near benchmark levels, or possibly a bit lower for more conservative investors. The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
• The economic forecast set forth in this presentation may not develop as predicted,
and there can be no guarantee that strategies promoted will be successful.
• Data provided by LPL Financial, Thomson Reuters, Goldman Sachs and Citibank.
• Investing in stock includes numerous specific risks including: the fluctuation of
dividend, loss of principal, and the potential liquidity in a falling market.
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