With major U.S. equity indexes at all-time highs, market participants have been hanging on comments from the Federal Reserve and U.S.-China trade negotiators.
Fed Chairman Jerome Powell signaled again that he’s open to lowering interest rates, and we anticipate it will happen at the July 30–31 Federal Open Market Committee meeting, with more cuts at subsequent meetings if needed. U.S.-China trade rhetoric has been relatively calm of late, but there are no signs of a breakthrough.
In the near term, we see attention shifting to bread-and-butter issues: Q2 earnings reports and the outlook for subsequent quarters.
Sluggish earnings growth is to be expected, according to consensus forecasts. This is well known by market participants and we believe it largely has been factored into stock prices. It’s a key reason—notwithstanding the S&P 500 reaching an all-time high—that the market has traded in a wide, volatile range for many months.
2019 is a consolidation year for earnings growth
S&P 500 earnings per share growth (y/y), actual & consensus estimates*
* Actual earnings growth from Q1 2015 through Q4 2018. Q1 2019 is actual data, but subject to revision. Q2 2019 and onward reflect the consensus estimates. Source - RBC Wealth Management, Refinitiv; data through 7/10/19
Even so, Q2 earnings results and management teams’ comments about the economy, trade/tariff disputes, and outlooks for future quarters could pose some challenges for the market, or provide an excuse for a pullback.
Will the earnings beats go on?
The consensus forecast for Q2 earnings growth recently slipped into negative territory, to a lackluster -0.3% y/y level. This is down from 1.2% two months ago and 6.5% in January. When all is said and done this reporting season, we think earnings “beats” will lift the Q2 growth rate back into positive territory, perhaps by a couple of percentage points.
However, the proportion of beats may not reach the above-average levels of recent seasons and, more importantly, the magnitude of beats (the degree to which they exceed estimates) seems unlikely to match previous quarters, in our view. There could also be more high-profile earnings misses by U.S.-based multinationals given the early reporting trends by multinationals headquartered overseas.
Management teams’ guidance about future quarters, and their thoughts about domestic and global economic trends, trade, capital spending, margins, and more will of course be under the microscope.
Some companies will likely update their full-year estimates, but companies often wait until Q3 industry conferences or the Q3 reporting season to do so. Regardless of the timing, we think the consensus forecast for Q4 earnings growth of 6.8% y/y is vulnerable to further cuts.
Even though these developments could create market volatility during the Q2 reporting season, it is unlikely to be enough to break the bull market, in our view. Such events are to be expected when earnings momentum slows, and we think much of this has already been factored into the market.
A tough act to follow
The full-year outlook is also unspectacular. After torrid 23% y/y earnings growth in 2018, the consensus forecast calls for just 2.4% y/y growth in 2019, nearly equivalent to RBC Capital Markets’ estimate. Consensus revenue estimates have been scaled back to the low single digits, compared to an average of 8% last year.
The main culprits are waning economic momentum combined with trade tensions and uncertainties. U.S. manufacturing data suggest a range of outlooks from weak growth to a modest contraction, while manufacturing in Europe, China, and Japan is contracting. U.S.-based companies’ capital spending plans have eased recently and could pull back further given the trade uncertainties not only with China, but also with the EU, Japan, India, and the list goes on. Another bout of global disinflation hasn’t helped corporate trends, either.
Arithmetic is also a factor. Low tax rates, which boosted 2018 U.S. earnings by 7–8 percentage points, no longer factor into the year-over-year earnings growth calculation. Furthermore, robust 2018 earnings growth set a high bar that will be difficult to exceed by any meaningful margin, in our view.
The combination of lower earnings estimates and the market’s recent rally has resulted in higher-than-average price-to-earnings ratios of 18.0x and 17.1x for 2019 and 2020, respectively, based on RBC Capital Markets’ estimates (see chart above). In our view, these valuations are not overly expensive compared to the 16.0x 10-year average, nor should they constrain stock prices.
S&P 500 valuation is elevated, but not overly expensive
Annual earnings per share forecasts (left); forward price-to-earnings ratios (right)
Source - RBC Wealth Management, RBC Capital Markets (RBC forecast); data through 7/10/19
The long and winding road
Profits and revenues don’t grow in a straight line, even during expansion cycles, so we are not unduly surprised by recent pullbacks in earnings growth estimates. But Q2 earnings season will likely have some rough patches that could create market volatility in the short term.
As long as economic trends don’t deteriorate meaningfully and trade tensions don’t heat up to the degree that global economic growth is further at risk, we think the market can work through this earnings lull. Accordingly, we continue to recommend a Market Weight or benchmark position in U.S. equities.