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Barings Investment Institute
Macroeconomic & Geopolitical

All Eyes On Earnings

7 February 2019 - 4 min read

The politics are chaotic, the macroeconomic data are contradictory and the central bank pronouncements are confusing. Amid all the noise, earnings may be the best economic indicator for the investors in the coming year.

The politics are chaotic, the macroeconomic data are contradictory and the central bank pronouncements are confusing. This is the time, perhaps, for investors of all stripes to stare longer and harder at earnings—the best, most solid evidence of a firm’s ability to support its debt obligations, with something left over for shareholders.

The evidence here is not entirely clear either, but there are trends that bear watching. Rising wage pressures could snuff out earnings that are already under pressure, while successful capital expenditures could boost productivity in ways that extend the cycle.

As we move deeper into the reporting season, corporate results are clearly slowing with the rest of the economy. Current forecasts compiled by Bloomberg show earnings are due to grow roughly 6% this year. That’s not too bad after last year’s 24% earnings-growth-a-palooza fueled by large tax cuts.

Moreover, at roughly 16 times forward earnings, stock valuations are much less challenging than they have been in the recent past.

“Rising wage pressures could snuff out earnings that are already under pressure, while successful capital expenditures could boost productivity in ways that extend the cycle.”

If the market is trading here, however, it means that many folks don’t believe the picture will improve from here. So far, Bloomberg reports that two-thirds of firms have beat expectations—lower than usual, and firms are exceeding revised forecasts that analysts adjust up to the last minute.

The revisions themselves tell a darker story. While they race to catch up to a world in which top-lines will face pressures as overall demand slows, operating margins will wither from higher commodity costs as earnings suffer and financing costs rise.

“We have all been staring at the Phillips Curve for so long that it’s hard to believe inflation has not ticked up with unemployment near 50-year lows.”

S&P 500 NEXT 12 MONTH PRICE TO EARNINGS RATIOSOURCE: FACTSET, AS OF JANUARY 30, 2019

 

S&P 500 NET FORWARD EARNINGS REVISIONSOURCE: FACTSET, AS OF JANUARY 30, 2019

The bellwether stocks are still all over the place.

Proctor & Gamble beat expectations riding strong consumption trends, especially in developing markets, and management raised expectations for this year’s sales. Results from Microsoft and Boeing looked strong, too.

More chilling for the market, Caterpillar missed earnings forecasts badly, blaming deteriorating Chinese demand and fresh allowances for possible bad debts within its financing division. Chipmaker Nvidia linked many of its woes to China, too.

A global recession this year still seems a stretch given the strength of the U.S. consumer. The worrying stories from China look a little exaggerated as the government in Beijing has begun deploying monetary and fiscal support that should become evident over the next quarter or two.

Rising commodity and financing costs will surely eat into earnings for many firms, but these are hardly insurmountable. Good management practices can knowingly smooth the volatility of commodity prices, and interest rates may be rising but they remain at historically low levels.

Still, there are two much bigger drivers of earnings that investors must struggle to assess as they decide whether to believe current forecasts.

Perhaps the biggest risk to earnings at this stage comes from rising labor costs amid tight labor markets in the United States, Japan and even many parts of Europe. We have all been staring at the Phillips Curve for so long that it’s hard to believe inflation has not ticked up with unemployment near 50-year lows.

There are early signs of wage pressures, but they will remain muted as long as inflation expectations remain under control. It’s difficult to imagine this changing in a week when investors fret that a 2.5% Fed Funds rate is too high. But even a whiff of unexpected wage inflation will roil markets.

U.S. 10 YEAR BREAKEVENSOURCE: FACTSET, AS OF JANUARY 30, 2019

 

U.S. PRIVATE DOMESTIC FIXED INVESTMENT (Q/Q ANNUALIZED)SOURCE: FACTSET, AS OF JANUARY 30, 2019

Yet good firms can fight these cyclical pressures on earnings by reinvesting in their business and finding ways to get more from an increasingly expensive labor force. The principal logic behind President Trump’s tax cuts was to encourage firms to reinvest this windfall into new jobs and new production facilities.

So far, much of this cash has been channeled back to shareholders through buybacks and dividends, though there was a brief surge in capital expenditures last year. Corporations are unwieldy beasts, so it may be premature to conclude that the recent deceleration is a trend. If firms don’t start making reinvestment a central part of their future strategies, however, the global economy will be treading water for a long time.

All else equal, slowing growth will mean slowing earnings, leaving investors to decide whether the recent market sell-off means valuations have adjusted enough to compensate.

This year, recession risks continue to remain low. The earnings picture next year and beyond, however, will depend on how well corporate managers see through political, monetary and fiscal uncertainty to invest in their own productivity.

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