Can US earnings support equities?

The US second-quarter (Q2) earnings season was seen by many investors as a welcome break from geopolitical worries and macroeconomic noise. Unfortunately, the break did not last long as investor attention swiftly returned to trade tensions and the outlook for central bank policy. Yet, valuable information has been gleamed since early July on the health of corporate America.

Strong quarterly numbers

First, US earnings are still growing. At the onset of the earnings season, the market was looking for a small contraction year-on-year (yoy) in S&P 500 earnings, a number we highlighted as very cautious. The Q2 growth rate is likely to smash market expectations and come in above 3% yoy.

In Europe, although less reliable due to differences in currencies, reporting frequencies and accounting standards, quarterly growth is still set to be around +2.5%.

US Q2 earnings growth may be low by historical standards, partly due to earnings growth of 25% between April and June 2018 on the back of the tax cuts. However, these numbers should dissipate fears of an earnings recession, or two consecutive quarters of year-on-year declines in earnings growth, in 2019.

Decent profit margins

Second, US net profit margins are stable. Rising wages are often cited as a significant downside risk to profit margins for American companies. Yet, with sales expanding by around +5% in Q2, companies’ profitably remains healthy. We believe that a combination of tight cost management and further efficiency gains should prevent shrinking margins.

Earnings outlook

Finally, US earnings expectations have stabilised. Consensus expects 2.3% earnings growth in 2019. This is unchanged from a month ago, suggesting that negative earnings revisions may have ended.

We continue to anticipate 5% earnings growth this year. However, consensus expectations for growth of +11% in 2020, are still too high in our opinion. That said, on an absolute number basis, factoring in higher growth in 2019 and lower growth in 2020 should leave earnings per share at around $180, broadly in line with consensus.

Earnings to support US equities

In the short term equities are likely to remain volatile as investor sentiment – and so valuations – swings from “fear of recession” to “hope of recovery”. Over the medium term though, prospects for earnings and dividends have the largest impact on markets as, unlike valuations, they are not mean-reverting.

With that in mind, the latest quarterly earnings growth is encouraging. While earnings expectations for 2020 may be revised lower, we expect growth to persist. This is why we remain constructive on US equities over the medium term.

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