With many developed market firms having reported first-quarter results, we can say without doubt it’s been an unusual earnings season. Strong beats were met with little investor cheer. The worry: Earnings are close to a peak. Yet we see more room for earnings to climb this year and next, and reaffirm our overweight to U.S. equities.
The muted market reaction to strong earnings has been most evident in the U.S., as shown in the chart below.
Tax cuts have helped many U.S. companies post their best earnings growth in years. This is reflected in the sharp spike in analysts’ earnings per share (EPS) estimates for S&P 500 companies since the first quarter earnings season began in mid-April (see the orange line). Yet S&P 500 Index performance (the green line) has not followed suit, a break from the recent past when market moves mirrored earnings upgrades. European and Japanese earnings results have been somewhat weaker, but average price reactions in all three regions have been disappointing. Market moves for stocks in the day following earnings reports are at the lowest levels since 2011 in Europe and have been negative in Japan the last two quarters.
As good as it gets?
Sentiment has improved as earnings beats keep rolling in, and equity markets have risen over the past month. A sluggish market reaction to stellar results reflects investor worries that earnings may be nearing a peak, in our view. More reserved guidance from company management teams has stoked these concerns. U.S. tax cuts helped propel year-over-year EPS growth for S&P 500 companies to nearly 24% in the first quarter, the highest since the third quarter of 2010. Outside the U.S., the pace of earnings growth moderated, and stronger local currencies have pressured sales growth in Europe and Japan.
We do expect the rapid pace of earnings growth to slow. Recent strength, partly driven by one-off tax cuts, sets a high bar. Macro uncertainty has also increased amid trade tensions and U.S. fiscal stimulus at a late stage in the economic cycle. Growth and policy fears, it seems, have overshadowed current strong company fundamentals. Yet we believe companies will maintain a tight grip on expenses to shield margins from rising costs. With solid corporate health across regions, our base case is that the cycle has room to run. U.S. companies in particular are flush with cash from strong profits and lower taxes. This should boost corporate spending on buybacks, mergers & acquisitions and capital investment. Equity prices do not appear to fully reflect these prospects, though they have already baked in the lower tax rates that led stocks to record highs in January and have adjusted to modestly rising interest rates.
Against this backdrop, we see stronger earnings from companies that can generate sales growth and control expenses, as input costs inch higher and the economic cycle matures. We see better prospects for sales growth in the U.S. than in other developed markets. The U.S. has the healthiest ratio of earnings upgrades to downgrades globally, and economic data look solid and consistent with an expansion. Within the U.S., we prefer high-margin sectors with strong cash flows, such as technology, over low-growth defensives.
The iShares Core S&P Mid Cap ETF (IJH) was unchanged in premarket trading Wednesday. Year-to-date, IJH has gained 1.71%, versus a 1.59% rise in the benchmark S&P 500 index during the same period.
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