April 09, 2019

The coming earnings recession: A cause for concern?

Stocks have continued to power higher in early 2019 and new all-time highs are within striking distance. Meanwhile, the U.S. Treasury yield curve is signaling slower economic growth ahead and first-quarter earnings expectations for the S&P 500 are moving lower. What gives? Is there an explanation for this seeming disconnect?

First of all, we’re coming off an unusually strong year for earnings in 2018 so companies are facing tough year-over-year comparisons. Fueled in large part by the cut in the U.S. corporate tax rate from 34% to 21%, earnings for the S&P 500 rose 23% in 2018. The tax windfall enriched corporate coffers, providing a tailwind to U.S. economic growth.

Fourth-quarter earnings were better than feared and stocks rebounded from their previously oversold position. However, given lingering macro concerns, cost pressures, and typical pre-reporting guidance trends, first-quarter EPS estimates have come down about 10% since the beginning of the year. Three months ago, the Wall Street consensus was looking for EPS growth of 5.3% in the 1Q’19 and 7.3% for the full year (per Refinitiv). Those estimates currently stand at -2.0% and 3.3%, respectively (see Chart 1).

EPS estimates for the Energy, Materials and Information Technology sectors have fallen the most. It’s probably no coincidence that those sectors all have significant exposure to global trade and the outcome of the U.S.-China trade talks.

According to FactSet, 1Q EPS estimates for the Energy sector are calling for an 18% decline versus a 16% increase 90 days ago. This has occurred despite a meaningful increase in the price of crude oil. In the case of Exxon Mobile (XOM), the diversified energy giant is pivoting to a focus on long-term investments in upstream production which comes at a cost to near-term earnings. Estimates for Chevron (CVX), the second largest U.S. energy company, have also declined double digits as refining margins have been under pressure and it has been devoting more resources to the Permian Basin.

EPS estimates for the highly-cyclical Materials sector have also fallen with the group now expected to report an aggregate decline of 12%. A weaker global demand outlook is mostly to blame. However, the most recent economic data points from China have been encouraging and we expect a rebound later in 2019.

The Information Technology sector, which is coming off a very strong year with the highest IT spending growth in over a decade, is expected to see a 3% EPS decline in the 1Q. While the 2019 outlook still looks healthy overall, the more cyclical semiconductor industry is going through one of its periodic corrections. As a result, estimates have been slashed (especially for memory suppliers). In addition, the maturation of the smartphone market and disappointing iPhone unit volumes have had a negative ripple effect on the electronics supply chain. Nonetheless, the Philadelphia Semiconductor Index is hitting all-time highs on the expectation of renewed growth in the second half of the year after clearing out an inventory overhang in the coming months. We’re also in the camp that is forecasting a resumption of earnings growth in the 2H’19. Of course, this assumes a successful conclusion of the U.S.-China trade negotiations.

 

 

Looking ahead, earnings season officially kicks off on April 12 when the big banks start to report. We will be watching to see how much of an impact the recent decline in long-term U.S. Treasury interest rates relative to short rates (i.e. a flattening yield curve) has on net interest margins for these financial institutions. We don’t think the changing interest rate environment is fully baked into numbers yet but it could be at least partially offset by improving loan growth. It’s also worth noting that a flattening (or potentially inverted) yield curve is a less reliable predictor of the economy and of corporate earnings than in the past given the environment of structurally lower interest rates that we expect going forward.

So should investors worry about an “earnings recession” (i.e. two consecutive quarters of declining year-over-year earnings)? We don’t think so. Consensus estimates (as tracked by Refinitiv) are still assuming that earnings growth will resume in the second quarter, though at a modest pace (2.8%). Even if that forecast proves to be a little too optimistic, we would expect some improvement later in 2019 given that our slow and steady growth outlook remains in place. 

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