Following a blockbuster Q1 earnings season in which EPS rose at the fastest pace since the financial crisis, yet which saw a surprisingly muted market reaction perhaps as a result of growing global protectionism fears coupled with rising rates, a slowdown in China and generally tighter financial conditions, traders turn their attention to the second quarter earnings season which officially begins on Friday the 13th.
As usual, the big banks are among the first to report, with Citigroup, JPMorgan, PNC Financial, Wells Fargo, Bank of America, and BlackRock all reporting results by July 16. In total, 87% of S&P 500 market capitalization will report 2Q results by August 3.
What to expect?
According to Goldman’s chief equity strategist, while modestly below Q1’s blockbuster 25% EPS increase, results are still expected to be strong, with consensus expecting 20% year/year EPS growth.
Here Bank of America’s Savita Subramanian chimes in predicting that EPS will come in modestly better than analysts expect, hitting 22% YoY supported by very strong results from early reporters, positive (though decelerating) US data surprises, better-than-expected US GDP growth (which is tracking 3.6% in 2Q vs 2.3% in 1Q), and strong ISM indices.
With just days left until the start of earnings reports, Wall Street analysts are still revising up estimates; typically they cut estimates by around 3% in the prior three months. Sales growth is expected to remain healthy at 8% YoY (similar to in 1Q). A weaker average US dollar relative to the year ago quarter should contribute about 1ppt to YoY sales growth, and higher oil prices— WTI +40% YoY on average—should also benefit growth.
In some good news for the Fed, if not so good for corporate employees, while profit margins are forecast to expand by 88 bps to an all-time high of 10.9% – which suggests that wages continue to remain subdued, while limiting the “threat” of a wage induced inflation spike – this will be aided by a 14 pp reduction in the statutory corporate tax rate.
However, as Kostin notes, strong 2Q earnings growth is not just a function of lower corporate tax rates, as sales are also expected to rise by 11%, which would be the fastest pace of year/year revenue growth since 3Q 2011, thanks to a weaker average US dollar relative to the year ago quarter, as well as higher oil prices— WTI +40% YoY on average— should also benefit growth. Pre-tax earnings are also forecast to climb by 13%.
Drilling down on specific sectors, earnings are expected to rise in all 11 S&P 500 sectors, with Energy and Materials earnings growth set to pace the market at 135% and 40% year/year, respectively, largely thanks to the 16% YTD surge in Brent. Consumer Staples EPS is expected to be roughly flat year/year, but results in that sector and Health Care are complicated by CVS Health Corp’s recent acquisition of Aetna and subsequent sector reclassification, according to Goldman. Consumer Staples and Health Care EPS are also expected to grow by 8% and 9% in 2Q, respectively.
One question investors have is whether this earnings season will see the surprisingly muted response to earnings beats observed in Q1, while punishing those who missed. Goldman believes that this time around, investors will be more lenient, to wit:
We expect the prevalence of earnings beats will moderate from an impressive 1Q rate but the market will reward beats more. In 1Q, S&P 500 EPS grew by 24% (7 pp faster than consensus estimates) and 55% of companies beat consensus EPS estimates by at least 1 standard deviation, the highest level since 2Q 2010. A slightly weaker macroeconomic environment will result in earnings beats normalizing from elevated 1Q levels. However, firms beating EPS estimates outperformed S&P 500 by only 44 bp on the day after reporting, well below a historical median of 103 bp. One reason is that positioning was already long: our prime services colleagues’ net leverage data show that net length was above-average in 1Q reporting season. In contrast, net leverage recently fell below the 10th percentile vs. the last 12 months.
Additionally there is material room for upside, as analysts do not believe the conditions that led to strong 1Q beats will continue: as shown in the chart below, consensus estimates of 2Q, 3Q and 4Q 2018 EPS growth have barely changed since the start of 1Q reporting season.
And while Q2 earnings will hardly disappoint, traders will eagerly await guidance from management teams on two key issues, the strengthening dollar and protectionism in the context of escalating trade wars.
On the first, front, the USD weakened in 2Q vs. the year-ago period, but according to Goldman, its recent sharp rise suggests it could become a headwind to S&P 500 sales growth.
The trade-weighted USD was 3% weaker on average in 2Q 2018 than 2Q 2017, benefiting S&P 500 sales growth. Info Tech, Materials, and Energy are the three sectors with the largest share of sales from abroad and also rank as the top three sectors based on consensus estimated 2Q sales growth. However, the trade-weighted USD rose by more than 5% during 2Q, suggesting the dollar could become a headwind to exporters. Internationally-exposed stocks lagged in line with strength in the USD.
Which leaves tariffs as the biggest risk to market sentiment, although according to Kostin, the potential impact to aggregate S&P 500 EPS – for now – is limited given exports to China comprise just 1% of US GDP. Even so, despite their limited aggregate impact, tariffs will have a disparate influence at the stock level, especially on firms with high China sales and high reliance on imported COGS.
Morgan Stanley is less sanguine, and in a Sunday note from chief equity strategist Michael Wilson, the bank writes that “we do think that 2Q earnings season will bring an inevitable acknowledgement from companies that trade tensions increase the risk to forward earnings estimates, even if managements don’t formally lower the bar.”
Bank of America echoes Moran Stanley’s caution and tells clients to beware any deterioration in corporates’ outlooks…
This quarter we will be paying close attention to management guidance and commentary for any deterioration in outlooks driven by uncertainty around growth or trade, which could halt the capex recovery and stall confidence. So far, so good – management has continued to guide above analysts’ upwardly revised earnings estimates (Chart 5), and has also continued to guide above analysts’ forecasts for capex (Chart 6), though the capex guidance ratio fell to slightly below average levels as of our latest update in June.
… As well as further pressures from higher wages and input costs.
Companies who cannot pass through higher wages and/or input costs could also be at risk. 10% of companies cited higher labor costs in 1Q18 vs 8% in 4Q17 (the highest since we began tracking in 2015), and wage growth is at post-crisis highs (Chart 7). We have not seen a hit to margins yet, but operating margins have softened in Consumer Discretionary (the most labor-intensive sector) plus several others. We are monitoring our BofAML Corporate Misery Indicator (Chart 8), a macro proxy for profitability that has been strongly correlated with, and sometimes leads, the profits cycle. This indicator has been volatile in recent months, but wage growth has generally outpaced CPI. If it turns south, profits are likely to decelerate, and a margin squeeze could be in the works, unless demand and/or pricing pick up.
In conclusion, when it comes to the most important variable, namely how single stocks – and the broader market – will respond to Q2 earnings, the answer may not be found in either backward looking revenue and EPS numbers, or forward looking guidance, which changes day to day based on the macro picture, but what Trump may tweet at 6 am on any given day, and how China will respond. And those, as the past 6 months have shown, are completely unpredictable
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