Earnings Slowing, but Expanding Enough to Support Equities

Jeff Mortimer

We believe that a continuation of the global expansion should allow corporate profits to improve next year and will not lead to an earnings recession globally. However, in the U.S., we think consensus estimates may be too optimistic.

Investors have understandably been concerned about corporate profitability in the midst of a global manufacturing slowdown and trade uncertainty. Both factors are negatively weighing on corporate earnings, as evidenced by an estimated 2.3% year-over-year earnings decrease for S&P 500 companies during the third quarter. While these results were better than expected, investors are questioning whether the deterioration in earnings has further to go or whether profits will begin to rebound.

Let's take a look at why corporate earnings have declined, our forecast for profits moving forward and what that likely means for the equity markets as we head into next year.

Putting Slow Earnings Into Perspective

Earnings growth has been on the decline since the start of the year, but it is important to understand the reasons for the deterioration. In 2018, earnings got a boost from the 2017 corporate tax cuts and deregulation. The downside of 2018's record earnings growth is that it is hard to sustain such a high level. In addition, the global manufacturing slowdown, the strong U.S. dollar (which makes American goods more expensive for non-U.S. customers) and trade uncertainty have also softened demand for capital goods and business investment.

Even as earnings have slowed, domestic equity markets sit near or at all-time highs. This suggests that markets are pricing in an easing of trade tensions and some type of partial deal, which should lead to a recovery from this slow down in earnings growth.

Earnings Outlook

Our economic outlook for 2020 assumes a modest rebound in growth, partly due to an easing of trade tensions and evidence of a bottoming in manufacturing weakness both here in the U.S. and globally. In addition, other areas of the economy, particularly the U.S. consumer and labor market, remain healthy and should continue to support the global economy.

Historically, global earnings have peaked just ahead of or along with the start of U.S. recessions, while tending to bottom just after them. However, year-over-year earnings changes often pierce the zero line from the upside without leading to recession (See Exhibit 1). This information requires us to determine both whether earnings are going to be flat, and if that flatness will lead to recession.

Currently, we believe that a continuation of the global expansion should allow corporate profits to improve next year and will not lead to an earnings recession globally. However, in the U.S., we think consensus estimates, illustrated in Exhibit 2, are a bit elevated and may be too optimistic about the positive economic benefits of a trade resolution. In our opinion, a"phase one" deal, which we expect, should have a modest impact on economic growth and corporate earnings. From a bottom-up perspective, third quarter earnings calls with CEOs across industries suggest an improvement in earnings, but a more cautious outlook until trade negotiations become more definitive. However, we cannot rule out a setback in trade negotiations, which is why we have a more conservative take on the degree to which corporate profitability will improve.

We expect to see a modest pickup in fourth quarter earnings, which should bring S&P 500 operating earnings for 2019 within our forecasted range of $160-170. Based on our outlook for slow but positive economic growth and subdued inflation, we believe a reasonable estimate for 2020 S&P 500 earnings per share is between $165-175. This equates to a 5% to 6% year-over-year earnings growth rate. At this later stage of the economic cycle, earnings, rather than multiples, will likely support equity markets.

Outside the U.S., the earnings cycle is likely to rebound with the U.S. economy, assuming global trade improves as expected. Earnings for Eurozone and emerging markets companies should improve in an environment of slow global growth and muted trade tensions. While this is our base case, a deterioration in trade talks could further impact business investment decisions and weigh on profit margins.

Expect Modest Equity Returns With Some Bumps Along the Way

In our view, global equities will have room to move higher, given our expectations for a modest acceleration in earnings growth and accommodative central banks. Corporations should be able to deliver improved earnings growth given an expected pickup in demand, eased trade tensions and muted inflationary pressures, which will help keep a lid on costs. However, mid-single-digit earnings growth should keep equity returns more muted compared to this year.

We continue to recommend that our clients remain invested and ensure that they are at their target weights based on their investment plan. Given the uncertainty over trade, policy and politics, we have been adjusting our equity exposure over the last 18 months from an overweight posture to a neutral stance. We continue to maintain this allocation as we believe the market should continue to reward risk assets even in the midst of volatility.

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