The second quarter US earnings season is underway against a backdrop of solid US economic growth, but escalating trade tensions. Last week, equities and bond yields briefly fell after the US administration revealed a new list of USD 200bn worth of Chinese goods it plans to subject to a 10% import tariff, prompting China to warn that it would retaliate. Meanwhile, around 90% of companies reporting results early have beaten both sales and earnings expectations, and by a larger than average margin. The question for investors is whether the positive impact on equities from upbeat earnings could be undermined by the negative effect from trade frictions.
We expect US corporate profit to remain solid, driven by robust macroeconomic fundamentals. Business sentiment is near record highs, S&P 500 capital spending was up 24% in the first quarter and monthly net job gains averaged more than 200,000 in the first-half. The strong labor market is supporting solid consumer spending, while tax reform and higher government spending have provided an extra boost. We expect GDP growth of 3.0% this year and 3.2% next year, the best two-year stretch since 2005–06.
Overall, we expect 23–25% earnings per share (EPS) growth for the S&P 500 in the second quarter on 9% revenue growth – among the best growth rates since 2011. Our forecast for fullyear 2018 EPS growth is 19% and 6% for next year. If trade tensions dissipate the risk to these forecasts is to the upside. But last week’s escalation increases the probability of damaging trade dispute with significant economic and market impacts:
- We estimate a maximum direct negative impact on S&P 500 EPS growth of 4.5ppts if all tariffs proposed by the Trump administration are implemented. This assumes the USD 200bn of tariffs is implemented and China responds proportionately; there is a further round of USD 200bn with similar retaliation; and that tariffs on USD 350bn of autos are increased from 5% to 20-25%. The total also assumes that S&P 500 companies do not pass on the costs of tariffs and there is no product substitution, suggesting that the direct hit could be even smaller. With earnings on track to grow close to 20% this year, this direct cost might not seem too serious.
- But second round effects could be at least as significant. The Federal Reserve has already noted that some businesses are citing the impact of trade tensions in delaying investment and hiring decisions, with a knock-on effect on orders and revenues elsewhere in the economy. So far, the breadth and magnitude of this pull-back appears quite limited. However, as the range of goods subject to tariffs widens, supply chain disruption grows, and the ability to substitute goods from alternative origins falls, increasing the impact on consumers. A trade conflict could also have an adverse effect on investor sentiment.
Even more than usual, management team comments about expectations for upcoming quarters will be important. With trade frictions mounting, some companies might express caution. Also, in our view, the latest and potential further escalations in the tariff war are not yet fully priced into equities, while a further spread into non-tariff protectionist measures can’t be excluded. The positive fundamentals should help support equities, but in an environment of increasing trade risk it is prudent to consider downside equity protection and counter-cyclical positions, such as long duration US Treasuries, that should perform in the risk case.
US earnings growth appears on track for another bumper quarter supported by solid economic fundamentals. Early reporters have beaten expectations and we expect another quarter with more than 20% S&P 500 EPS growth. But trade tensions continue to escalate and additional tit-for-tat tariff increases can’t be excluded – a risk that does not appear to be priced into US stocks.