As expected, corporate America delivered little in the way of earnings growth in the third quarter. S&P 500 Index earnings fell around 2% year over year, about 2 percentage points above October 1 estimates (source: FactSet). That doesn’t sound great, but given the economic headwinds, the result was better than some had expected. In addition to tariffs and trade uncertainty, those earnings headwinds in the third quarter included:
- Falling oil prices, which led to a sharp drop in energy sector earnings
- A rising U.S. dollar, which weighed on international earnings for multi-national U.S. companies
- A 25% year-over-year decline in semiconductor industry earnings (partly related to the U.S.-China trade tensions)
- A challenging interest rate environment that curbed financial sector earnings
Although the quarterly earnings growth rate was hardly worth getting excited about, in reviewing third quarter earnings reports, there are a few notable takeaways.
Corporate executives’ commentary may reflect ebbing trade tensions. Of the first 451 S&P 500 companies to report, just 113 cited tariffs on their earnings conference calls, according to FactSet data. This is a 13% decline from the prior quarter’s total (and 25% below third quarter 2018). This may reflect improving prospects for a U.S.-China “phase one” deal or the trade story is becoming old news.
Guidance has been somewhat encouraging. Estimates for future quarters almost always drop during earnings season, and this most recent quarter was no exception. However, the 1.7% reduction in estimates for the next four quarters was smaller than average.
Healthcare was a standout performer. Revenues for the healthcare sector grew 15%, the best of the 11 S&P 500 sectors. Healthcare sector profits rose 9%, trailing only utilities. In addition, the sector produced among the biggest upside surprises on both the top and bottom lines. Healthcare companies have benefited from increased healthcare spending related to demographic trends as populations in the United States, Europe and Japan age. Healthcare companies also are relatively insulated from the U.S.-China trade conflict.
Profit margins have held up. The S&P 500’s operating margin last quarter was just 0.5% below a record high set in the fourth quarter of 2014 and matched in the first quarter of 2019 (source: FactSet). This showed that rising wage and other cost pressures have yet to significantly impede earnings.
Solid revenue growth. S&P 500 companies’ revenue grew at a better-than-expected 3.1% year-over-year pace in the quarter. Nominal gross domestic product (GDP), which includes inflation, grew 3.7% year-over-year in the third quarter. This pace of economic growth usually has provided a solid foundation for future revenue, as nominal GDP and revenues historically have been closely correlated. A steady flow of share repurchases, which boost earnings per share (EPS) by reducing share counts, has set the stage for potential mid-single-digit earnings growth without any increase in profit margins.
Although we expect S&P 500 earnings to grow less than the current consensus forecast of $179 (Source: FactSet), support for 2020 EPS growth could come from:
- Steady economic growth. GDP growth will likely be at the lower end of the economic expansion, at least during the first two quarters, but not drop into an official recession.
- Interest rates should eventually normalize, which could potentially support better financial sector profits.
- Progress on trade may lead to a resurgence in capital investment, which could lift earnings growth, especially for industrial and technology companies.
- Leading indicators of global economic activity have stabilized, which we see as indicating a potential pickup in U.S. manufacturing activity.
- Share repurchases will likely continue to boost EPS by decreasing the share count.
The U.S.-China trade conflict remains a wildcard, and we are unlikely to see a “clean” resolution anytime soon. In the absence of any progress on trade, earnings would likely stagnate near current levels, and there would be downside risk to a favorable 2020 forecast. Any small steps forward on trade could increase business confidence and spark capital investment, both tailwinds for corporate profits. The tariffs threatened for December 15—impacting many consumer goods—could be removed as part of a potential “phase one” deal with China. There is also a possibility the tariffs implemented in September could be reduced, although that has been a key sticking point in the negotiations to date.
Some investors may think stocks have gotten ahead of themselves with the S&P 500 near all-time highs. Earnings growth prospects for 2020, mild inflation, and low interest rates, may be enough to support stocks at current valuations. A favorable outcome on trade could potentially justify higher valuations and support higher S&P 500 levels.
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 FactSet and LPL Financial.
- All investing involves risk including loss of principal.
- All indices are unmanaged and cannot be invested into directly.