Earnings Update: Five Key Observations
Image source: Pixabay

Earnings Update: Five Key Observations
Image source: Pixabay

Earnings Update: Five Key Observations
Image source: Pixabay

Earnings Update: Five Key Observations
Image source: Pixabay

Fourth quarter earnings results are mostly in the books. It was not a blowout quarter by any stretch?—?earnings growth is tracking to about 7.5%, according to Thomson Reuters, only a below-average 1.5% improvement on the estimate at the start of the reporting quarter. But 7.5% earnings growth, along with 5% revenue growth, is nothing to sneeze at [Figure 1]. Further, policy optimism on Wall Street and among corporate management has helped full-year estimates for 2017 hold up relatively well. This week, we share five observations about fourth quarter earnings season so far.

Earnings Update

Earnings Update

Earnings

Five Key Observations

Observation #1: Policy Talk Abounds

Market participants have been focused on the implications of a Trump presidency since Election Day. That focus has not changed during earnings season, with tax policy dominating discussions on earnings conference calls. In fact, of the first 317 S&P 500 companies that reported, tax policy was mentioned on 85 of the earnings calls [Figure 2]. Regulation?—?of particular interest for financials?—?and trade policy have also garnered a lot of attention. These policies have the greatest potential to influence broad earnings, while the rest of the topics in Figure 2 are either more sector specific or more likely to have only a small impact.

We still lack clarity on what tax reform and other policies out of Washington will look like. But the latest headlines out of Washington and actual earnings results have given us no reason to change our belief that policy changes may add meaningfully to earnings growth once implemented. The latest stock market gains are likely pricing in some of this policy impact, with the forward S&P 500 price-to-earnings ratio (PE) over 17. We may start seeing the impact of policy changes on earnings as early as late 2017, but any potential earnings boost is more likely to come in 2018. Estimates vary widely, but we believe an expectation of a 3-5% lift from tax reform, infrastructure spending, and deregulation is reasonable.

Earnings Update

Observation #2: Guidance Has Generally Been Resilient

With more than 80% of S&P 500 companies having reported through February 17, 2017, S&P 500 estimates for 2017 have only fallen about 1.5%, according to Thomson Reuters data. Estimates are now calling for an 11% year-over-year increase, down from 12.5% as of January 1, 2017. On average, estimates fall between 2% and 3% during earnings season. The below-average reduction is an encouraging sign for growth. Looked at another way, a negative-to-positive preannouncement ratio of 2.4 for the first quarter is better than the long-term average (post-1990) of 2.7.


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The leading economic indicators we watch, including the Conference Board’s Leading Economic Index (LEI) and the Institute for Supply Management’s (ISM) Purchasing Managers’ Indexes (PMI), are also sending positive signals and support our forecast for a mid- to high-single-digit increase* in S&P 500 earnings in 2017. Should our forecast prove accurate, it would miss the January 1 estimate by 4-5%, much better than the long-term average of 8-9% (post-1985 based on Ned Davis data).


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*We expect mid-single-digit returns for the S&P 500 in 2017 consistent with historical mid-to-late economic cycle performance. We expect S&P 500 gains to be driven by: 1) a pickup in U.S. economic growth partially due to fiscal stimulus; 2) mid- to high-single-digit earnings gains as corporate America emerges from its year-long earnings recession; and 3) an expansion in bank lending; and 4) a stable price-to-earnings ratio of 18 – 19.

Observation #3: Wage Pressures Yet to Impact Profit Margins


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Many have been warning about profit margin compression for the past few years based on mean reversion (excess profits bringing in competition, which can pull margins down) and on expected wage increases as the labor market tightens. Although corporate America has seen some profit margin compression since the highs two years ago, all of it can be attributed to the energy downturn. According to FactSet data, S&P 500 operating margins have fallen from a multi-decade high of 14.6% in the fourth quarter of 2014 to the latest reading of 13.7% for the fourth quarter of 2016. During this period, energy sector operating margins have fallen from about 12% to zero, essentially accounting for all of the compression at the S&P 500 level [Figure 3]. The energy sector is unlikely to return to the margins produced at $100/barrel oil prices anytime soon, if ever, but the sector should be able to recover at least half of the recent margin compression should oil prices stay in the $50s or higher, as we expect.


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It is reasonable to expect profit margin compression from record highs as the economic cycle matures and wages, corporate America’s biggest cost line item, accelerate. Based on the U.S. Bureau of Labor Statistics’ measure of wage growth (average hourly earnings), wage inflation slowed from 2.8% in December 2016 to 2.5% in January 2017. That pace of wage inflation and steady job gains (an average of 195,000 jobs added over the past 12 months) are enough to support two or three rate hikes from the Federal Reserve (Fed) this year but are putting little pressure on corporate profit margins thus far.

Earnings Update

Observation #4: Financials (Mostly) Shine

Financials were the clear winner through the first month of earnings season, having generated the fastest growth, at over 20%, and the most upside, at over 5%. The environment has been favorable for banks with a steepening yield curve (long-term interest rates rising more than short-term rates) and a pick-up in economic activity. Strong stock market gains, healthy credit markets, and robust trading activity have boosted capital markets firms. But a sharp decline in financials’ earnings last week (February 13-17, 2017) due to a large reserve taken by a property and casualty insurer culled a lot of the sector’s growth, and all of the upside [Figure 4]. The insurer-driven weakness does not take away from the double-digit earnings gains delivered in the quarter by banks and capital

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