Investors have become accustomed to a blistering pace of earnings growth in the US. Profits per share are expected to have grown by 23% for 2018, with a compound annual rate of 12% over the past ten years. Recently, however, the momentum has slowed, and there has even been talk of an "earnings recession." The consensus among analysts, based on individual company projections, is less alarming. Earnings growth is expected to come to a virtual standstill in the first half of this year, with a 0.4% contraction in the first quarter and a modest 1.8% increase for the second quarter.
Concerns about earnings have been fueled in part by moderating economic data. Retail sales, which have long been a pillar of strength for the US economy, fell 1.2% in December, the sharpest decline since September 2009. And globally, the outlook has also been lackluster. Economic data misses have now been more numerous than beats for the past 315 days, based on the Citi Economic Surprise Index. That is the longest run of weakness since 2008.
Still, investors have been anticipating a slowdown in earnings growth, and we believe it would be a mistake to become overly pessimistic about the outlook.
- Earnings growth has not yet entirely run out of steam. For the fourth quarter, US earnings per share still look set to grow by around 15%, far from an earnings recession. With around 80% of S&P 500 firms having reported, roughly two-thirds have beaten forecasts, in line with the long-term average. In addition, the price action following announcements for Q4 has been positive, suggesting that investors had been prepared for worse and over-discounted the weakness.
- The slowdown that we are seeing for the start of 2019 does not appear to be broad-based. The impending weakness partly reflects sector-specific headwinds, such as a maturing smartphone market, an inventory overhang in semiconductors, and energy firms contending with year-on-year declines in oil prices. We are also seeing a moderation in growth for some internet-centric companies. A broader metric of the earnings outlook, however, looks brighter. The current bottom-up consensus for the median company in the S&P 500 is for earnings growth of 3.5% in the first quarter, 6% in the second, and 10% for 2019 as a whole.
- The data does not point to a prolonged earnings slump. Leading indicators remain relatively supportive. The Fed's Senior Loan Officers survey do point to somewhat less easy access to capital, but banks are not yet tightening, on balance. In addition, the Chicago Fed's National Financial Conditions Index shows conditions are still looser than the average. Meanwhile, business activity still appears to be expanding, with the Markit Composite PMI rising to 54.5 in January, up from 54.4, and above the 50 market that separates expansion from contraction. This supports our view that a US recession is not imminent.
- Pauses in earnings growth are not unusual and don't always unsettle markets. Since 1982 there have been five episodes when last-12-month earnings growth was between -5% and 5% without an economic recession (1985, 1996, 1998, 2013 and 2016) after which earnings growth re-accelerated. Equity markets usually take these earnings slowdowns in their stride, taking the view that the pauses are temporary. In the five prior earnings pauses, the S&P 500 rose an average of 15% over the 12 months prior to the pause and then over 20% in the 12 months after the pause as growth again accelerated.
So while an "earnings recession" may be a catchy headline, investors need to make a distinction between an earnings pause (which is a fairly benign outcome for investors) and an earnings plunge driven by economic recession where profits usually fall by 20%. Based on the preponderance of economic and corporate profit evidence, a temporary pause seems much more likely than a plunge.
Earnings momentum in the US has slowed and there has even been talk of an “earnings recession.” We think it would be a mistake to become overly pessimistic about the outlook. Growth hasn’t entirely run out of steam, the earnings slowdown doesn’t appear broad-based, and pauses in earnings growth aren’t unusual, nor do they always unsettle markets.