Ready, set, go

Please note this blog post was published over 12 months ago and so may not include the most up-to-date information, for example where regulation around investing has changed.

Ready, set, go

For corporate America the beginning of January signals the start of Q4 earnings season. Earnings season is a look back event and it allows investors to gain insight into the financial health of some of the world’s largest institutions. Data on profits and sales help market participants make decisions on whether current price levels are justified.

Throughout 2017, and the first three quarters of 2018, earnings soared, helped along by loose monetary policy and a sizeable fiscal stimulus package. Tax changes reduced the Federal corporate tax rate from 35% to 21%. Cutting taxes for businesses is a Trump administration flagship policy to help promote ‘America First’.

The tax package boosting profits also helped fuel a record-breaking share buyback programme. This has been facilitated by the repatriation of cash balances, previously parked overseas to avoid paying tax at hitherto high rates. Once repatriated the cash sums attracted less tax and, in many instances, was used to buy back shares to boost earnings per share. At the same time companies have been increasingly borrowing money at low rates of interest, again buying back shares with the monies raised.

Expecting a faster rate of earnings growth investors pushed up share prices leading to high price earnings (P/E) ratios; the market’s P/E multiple peaked at 23.4x on 26th January 2018. However, in the cold light of day investors have reassessed the wisdom of putting a higher valuation on businesses that have borrowed money to buy back shares. The stock market P/E has since retraced to today’s level of 16.9 times earnings.

At this point 98 of the 500 listed companies making up the S&P500 index have reported sales and profits numbers. A reasonable sample but there is still a long way to go before we can judge the outcome across all corporate USA.

Based on the early sample, three quarters of firms reported ‘beats’ i.e. when corporations exceed analysts’ earnings expectations. Admittedly, these expectations had been lowered, against a backdrop of uncertainty around the Federal Reserve’s interest rate trajectory and trade tensions with China, but the better mood associated with exceeding expectations has helped market sentiment.

Historic/Expected Earnings and Sales Growth

Source: Bloomberg, data as of 24/01/2019

While earnings season mainly shows what has happened in the past it also has a forward-looking function. At each quarterly update companies provide analysts with future guidance on their profit outlook. Granted, this is where corporate managers play a little game. At the start of each year they usually try to ‘talk down’ numbers, hoping that as the year unfolds they will exceed their knocked down profit forecasts.

Looking at the chart above, and forecasts for earnings in 2019, we believe there are two forces at work. First, the boost from the lower corporate tax rate is starting to fall away. Second, analysts are trimming earnings for 2019 because corporate managers are playing the earnings game. In this context the big drop in earnings growth in 2019, relative to 2018, is less of a worry. Another thing to bear in mind is that 80% of firms reporting profits now are experiencing quarter-on-quarter growth in earnings and sales. This means the market is showing breadth of profits growth.

Once all companies have reported their profits for the final quarter of 2018 we think 2018 will be remembered as a year of incredible earnings for corporate USA. It has set the bar higher for this year making it almost impossible to repeat growth of over 20%. However, if, as expected, earnings guidance translates to forecast growth of 6-8% for all 2019 there is a reasonable chance that companies will exceed these levels when they report realised profits.

In the meantime, we eagerly await the results of those yet to round off the quarter 4 2018 reporting season thereby revealing what the final tally in earnings growth will be after Trump’s tax boost.

With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest. Past performance is not a guide to future performance. Tax rules can change at any time. This blog is not personal financial advice.

Personal Finance