It’s that time in the quarter again: starting next Friday, the big money center banks will report Q3 earnings, launching third quarter earnings season, which for the third consecutive quarter is expected to be stellar.
According to consensus, S&P 500 3Q EPS will grow by 21% Y/Y, which while a slight deceleration from the 24% and 26% earnings growth registered during 1Q and 2Q, will still be enough to extinguish fears for an imminent reversal in record corporate profitability.
Of note: both sales growth and tax reform contributed equally to first half EPS growth as revenues during the first two quarters rose by more than 10%, led by Energy (+108%) and Materials (+45%), according to Goldman. Meanwhile, Trump’s tax reform and the lower corporate tax rate accounted for 10% of earnings growth (excluding lower tax rates, EPS growth would have been 15% in 1Q and 17% in 2Q, still the fastest pace since 2011).
Commenting on what to expect during Q3 earnings season in his latest Weekly Kickstart note, Goldman’s David Kostin writes that the recent trend of double-digit revenue growth will continue with 11% sales growth in 3Q 2018.
Consensus expects that Energy (+31%) and Health Care (+19%) will provide the fastest sales growth at the sector level. Energy sales directly benefit from the rally in crude. WTI averaged $69 per barrel in 3Q, up 44% vs. last year. Information Technology is expected to grow 3Q revenues by a more modest 12% primarily due to the reclassification of GOOGL (consensus sales growth +23%) and FB (+34%) into Communications Services.
While Kostin notes that a key catalyst behind the upside surprise in first half earnings was the 200bps impact on EPS which was underestimated by Wall Street (and could represent a source of positive EPS surprise in 3Q), he notes that the ultimate driver of corporate sales growth is underlying economic activity.
As Fed Chair Powell stated in his speech this week to the National Association for Business Economics (NABE), the outlook is “remarkably positive.” In fact, the unemployment rate released this morning fell to 3.7%, the lowest level in 50 years. The National Federation of Independent Businesses (NFIB) survey stands at 108.8, the highest reading since the survey began 44 years ago. ISM non-manufacturing survey hit 61.6 this week, the highest level since the measure started in 1997.
And yet, as we gradually anniversary the base effect of tax cuts by the end of the year – at which point they will provide no new upside to earnings growth – a trio of new threats is emerging, all of which threaten to pull down profit margins in the coming year.
Kostin first previewed this danger last week, when he warned that the boost from tax reform will fade some time over the next 2 quarters, which will ratchet up pressure on corporate margins and most companies will suffer margin erosion as trade war ramps up. Meanwhile, firms with the ability to maintain or expand profit margins will become increasingly scarce and will likely be rewarded by investors. This is why Kostin introduced a list of 33 Russell 1000 companies with high and stable gross margins, which the Goldman strategist said would provide resilient to margin contraction as trade war escalated:
Fast forward to today, when Kostin doubles down on what he sees as the main threat to the bottom line, explaining that the primary investor concern going forward relates to downward pressure on profit margins from three sources:
- tariffs,
- wage inflation, and
- interest rates.
And while Kostin believes that investors will be dissecting 3Q earnings calls for insights about how firms will address these issues, he makes the following three observations about the three big risks to corporate profitability:
1. “Tariffs will have minimal impact on 3Q results for most companies given the bulk of the levies were not imposed until late in the quarter.”
Still, affected firms will likely address concerns on their earnings calls. In fact, some firms have already discussed the potential impacts. For instance, MU reported that gross margins for upcoming quarters will be pressured by the imposition of the 10% tariff. Furthermore, the aggregate impact of tariffs on S&P 500 profits will depend on the specific rate and scope of products covered. Specifically, as Kostin explained last week, if a 25% tariff is placed on all imports from China, our estimate of 2019 S&P 500 EPS, currently $170, could fall as low as $159, eliminating all of Goldman’s expected earnings growth.
Here, firms with high and stable gross margins will be best positioned to withstand input cost inflation regardless of the cause.
2. “Labor costs will continue to rise and put downward pressure on the margins of many companies”
Kostin writes that while he was reflecting on the tight labor market, the head of one S&P 500 firm asked him, “how does one grow a company without labor?” The simple answer: firms will need to boost worker pay in order to fill positions. This is why the Goldman Sachs economics’ Wage Survey Leading Indicator currently stands at 3.3%, the highest level this cycle. Meanwhile, Kostin also writes that AMZN’s announcement of a $15 minimum wage for all US employees has spurred discussion of economy-wide wage inflation. And while this change will not impact the 3Q results of the S&P 500’s 2nd largest employer, “investors will be observing the responses from other firms.” Another risk: tight labor market will start weighing on small businesses; in the latest NFIB survey, one-third of respondents reported labor cost or labor quality as the single most important problem affecting their business.
To address client concerns about rising labor costs, Goldman has updated its list of firms with the highest (GSTHHLAB) and lowest (GSTHLLAB) implied labor cost as a share of revenue. “The intuition underlying our analysis is that companies with low labor cost exposure will have less risk from labor inflation, which would compress margins, lead to negative EPS revisions, and weigh on share prices.”
3. Higher interest rates will weigh on margins for many companies.
The final concern expressed by Goldman clients is that rising rates will add to further downside on profit margins. Sure enough, the topic of last week was the sharp spike in US rates when the ten-year US Treasury yields jumped to 3.24% stands at the highest level in seven years. As we reported last week, the 36 bp backup in rates during the past month represents a roughly 2 standard deviation move, a shift that Goldman’s research shows is typically associated with negative equity returns.
And despite the biggest two-day drop in equities since May, the S&P 500 index remains resilient and even though it slipped by 1% this week, it trades at virtually the same level today (2880) as one month ago (2888). Incidentally, Goldman’s year-end 2018 target remains 2850 and its year-end 2019 target is still 3000.
Not everyone will cross unharmed: rising yields will weigh on firms with the heaviest debt load, as higher rates flow through to higher interest costs. Here, Goldman recommends investors focus on stocks with the strongest balance sheets: “Relative to Weak Balance Sheet companies (GSTHWBAL), our Strong Balance Sheet basket (GSTHSBAL) offers faster sales growth, albeit at a higher P/E premium (22x vs. 15x).“
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In conclusion, despite the mounting margin threats, Goldman remains sanguine, and its top-down earnings model forecasts S&P 500 net margins “will hover near current levels until 2020.”
We project margins will equal 11.0% in 2018 and 11.2% in 2019. In contrast, bottom-up consensus analyst estimates suggest margins will rise from 11.5% to 12.0%. The 80 bp gap in 2019 margin forecasts explains the $8 per share difference in our top-down EPS forecast of $170 and the bottom-up estimate of $178
While to some this baseline forecast may appear optimistic, there are numerous loopholes, the biggest of which is that should Trump place a 25% tariff on all Chinese imports – something which in light of recent trade, geopolitical and technological escalations appears to be inevitable – S&P profit growth will stall, and remain unchanged one year from today. As for how the market will respond, it may depend on China: should Beijing find itself it needs to sell more US-denominated reserves in order to support the Yuan, whether bonds or stocks as trade war intensifies, it is possible that a repeat of the near-bear market that took place in late 2016 will also be inevitable.
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