As I look at the current market I am reminded of the Yogi Berra saying, "It's déjà vu all over again." Just as we saw in 2015-16, markets are fretting about earnings growth and whether an earnings recession will lead to, or is signaling, an imminent economic recession. After stellar earnings growth in 2018 (20% growth over 2017), it is not surprising that leading strategists are questioning whether earnings can again clear such a high hurdle.
Recent evidence of a global slowdown, including the Federal Reserve's pivot to a more dovish policy stance, its downwardly revised growth forecast and a partial inversion of the Treasury yield curve has put this upcoming earnings season in the spotlight. Will an earnings recession (defined as two or more consecutive quarters of negative growth on year-over-year earnings) occur and indicate that an economic recession is on the horizon? Or will we conclude, as we did in mid-2016, that the evidence suggests the U.S. economy will recover from this soft patch and avoid an economic recession once again?
A High Hurdle but No Earnings Recession
2018 was an impressive year. Corporate tax cuts and a solid economic backdrop helped deliver earnings growth of greater than 20% for the S&P 500 during the first three quarters, before slowing to 13% in the fourth quarter as uncertainty about the pace of global growth and trade weighed on profits. While some analysts believe that there will be no earnings growth in 2019, we disagree.
Our forecast is for S&P 500 operating earnings per share to come in between $165 and $175, or about a 6 to 8% gain over 2018. As of the beginning of April, the consensus expectation is that first quarter S&P 500 earnings will be 4.3% lower than a year ago, which would make it the first decline since mid-2016. A deceleration in earnings growth is expected due to the fading impact of tax cuts, trade uncertainty, and sector-specific factors in the technology, semiconductor and energy sectors. However, we believe the bar has been lowered enough that we will likely see an earnings slowdown rather than a prolonged earnings recession. There are several factors that support this belief, including positive revenue growth and the Fed's pause, which has historically been a supportive environment for earnings growth.
Revenue Growth Still Positive
History suggests that an earnings recession is unlikely when revenues are still growing. As illustrated in Exhibit 1, all prior earnings recessions corresponded with sales-growth recessions. The solid blue line illustrates the 12-month change in earnings, with the circled time frames highlighting past earnings recessions. In each of these prior cases, the dotted line, which represents year-over-year sales growth, was always below zero. With sales growth comfortably in positive territory and first quarter revenue growth estimated to be up 5% from a year ago, we do not expect an earnings recession in the near to intermediate term.
The Fed's Pivot
The Fed has learned twice in the last three years that tightening monetary policy too quickly in a world still attempting to escape the memories of the financial crisis can be difficult. At its March policy meeting, the Fed made a complete U-turn from three months earlier, shifting from a forecast of two rate hikes in 2019 to zero. It also lowered its growth forecast for the U.S. and announced it would halt its balance sheet reductions in September.
While some took the Fed's more dovish stance as a reason to fear recession, Strategas Partners analyzed the Fed's last pause in 1995 and concluded that the market is more willing to reward companies that are growing. Their research found that companies with low valuations, high shareholder yield and the ability to grow free cash flow were the biggest winners during times when the Fed watched the game from the sidelines. In other words, companies that were able to grow earnings (and cash flow) were rewarded during this phase of the economic and market cycle.
In the 1995 market cycle, the technology sector was the greatest beneficiary three months after the Fed began its pause. So far, history is repeating itself. The technology sector is again the leading sector year-to-date within the S&P 500. This historic view illustrates that a pause in monetary policy provides a backdrop against which most companies can continue to grow their earnings. We believe this market should continue to reward companies that are growing given our view that the economy is still healthy overall.
A Flat Yield Curve
One outcome of the Fed's pause has been a lower and flatter yield curve with the spread between the three-month and 10-year Treasury yields recently inverting temporarily. While we pay close attention to the shape of the yield curve given that an inversion (when short-term rates are higher than longer-term rates) can signal an economic downturn in the future, we also recognize that a flat yield curve is common during periods when the Fed pauses. During the Fed's pause in 1995, the two-year to 10-year spread on Treasury yields remained relatively flat, similar to what is playing out this time around.
Our view is that the yield curve will remain flat for the near to intermediate term, but we expect the longer end of the curve to move gradually higher as the global economy begins to reaccelerate. We are already beginning to see green shoots of global economic growth, including an improvement in manufacturing data both in China and the U.S., and an improvement in survey data that suggests companies and consumers are more confident. This confidence may lead to more consumer spending and capital expenditures. Strong data points such as these bode well for a modest curve steepening once economic activity begins to manifest itself.
What If the Economy Avoids Recession?
History suggests that if the economy avoids a recession, equity markets can do well. As Exhibit 2 illustrates, the key to analyzing past market declines is to determine whether or not a recession followed. As long as the economy was able to avoid a recession for the 12 months following a decline, the S&P 500 index performed quite well. Although we've seen some softness in trade and manufacturing data, the labor market and the consumer remain very healthy. Our belief is that the recent growth slowdown is transitory and that both 2019 and 2020 will prove to be non-recessionary years.
Slower Earnings Growth Still Positive for Equity Markets
We believe companies should be able to clear what appears to be a lowered earnings hurdle and avoid an earnings recession. However, equity markets could be choppy as companies report results, even though a slower pace of earnings is likely priced into the market. Earnings should improve as the year progresses in light of an expected rebound in economic activity, low inflation and a more dovish Fed.
Our forecast of a mid-single-digit earnings return for the year should allow equities to move modestly higher over the next 12 to 18 months. Outcomes other than a positive resolution to trade talks, an orderly Brexit or a rebound in growth (currently priced into the markets) could negatively impact earnings. But for now, we believe the path of least resistance for equity assets continues to be up, and that Yogi will be proven right.