Perspective

Managers' views

Earnings is key to equity returns


Irene Lauro

Irene Lauro

Economist

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Equity market returns year-to-date have been strong, with the S&P 500 rallying 20%, despite a weakening global economy and intensifying trade tensions. Yet since the beginning of the year, earnings per share have barely moved. The rise in share prices has almost entirely been driven by easier monetary policy from the US Federal Reserve (Fed), supporting a substantial rise in the price-to-earnings (P/E) ratio. Moreover, if we look at the past 12 months the S&P 500 has risen only slightly, as markets experienced a sharp de-rating in the last quarter of 2018 followed by a near equivalent re-rating in early 2019. We believe that this leaves the market vulnerable to a correction as unless the Fed exceeds expectations in loosening monetary policy, the tailwind of multiple expansion is not likely to be sustained. Earnings will have a crucial role in determining equity returns as stock prices will be driven by the real state of the economy and its corporate sector.

All our cyclical indicators are still signalling that we are at a late stage in the economic cycle. While easier monetary policy has supported consumer credit conditions and the housing market, the corporate sector appears to be under greater pressure. In particular, US corporate profitability has deteriorated this year with profits shrinking in the first two quarters.

Trump’s tax cut masked an underlying deterioration

From an investor perspective, corporate profits matter because they are a key driver of equity returns. We find that post-tax profits are a better predictor of EPS than pre-tax profits. Last year, for example, pre-tax profits in the non-financial sector grew a mere 0.9% year-on-year (y/y), while earnings per share of the S&P 500 recorded a stellar performance, rising 21.8% y/y. This divergence can be largely explained by the reduction in the federal corporate tax rate from 35% to 21%, introduced by the 2017 Tax Cuts and Job Act, that masked the underlying deterioration in US profits.

Economic activity is not the only driver of profits. Our calculations of the effective tax rate from the national income and product accounts show that the corporate tax rate declined significantly in 2018. The effective average tax rate for corporations was 20% in 2017, and fell to 13.2% in 2018, enough to buoy the US stock market to record highs. The tax savings drove profits to new highs, as after-tax corporate profits grew 9.5% y/y, the strongest gain since 2012. This stimulus is beginning to fade, as the effective corporate tax rate has started to rise this year.

Rising labour costs to put pressure on margins

When an economy is in late cycle, unemployment usually falls further, making wage costs grow faster, and thereby putting greater pressure on margins. If companies are not able to pass rising costs on to consumers then margins will have to take the strain. Rising inflation is not likely to be sufficient to offset rising labour costs and weaker capacity use. As a result, earnings, and in turn profits, are likely to suffer. As fading fiscal stimulus exacerbates the effect of a slowing domestic economy, the downward trajectory of profits could give equity investors some cause for concern.

Economic outlook

As the economic expansion has matured, a tighter labour market has put upward pressure on wage growth, leading to a late-cycle drop in profit margins. Last year, the Trump administration's tax cut provided a substantial boost to post-tax profits, masking the anaemic growth of pre-tax profitability of the US corporate sector. The tax cut also drove investor confidence to high levels, helping support the S&P 500.

However, the fiscal stimulus is now behind us and the real state of the US corporate sector will start to matter for equity returns. We are forecasting the US profits recession to continue throughout next year, as rising labour costs and weaker capacity utilisation will put margins under further pressure. The earnings per share of the S&P 500 have hardly grown so far this year, while stock prices significantly benefitted from easier monetary policy. In this environment the market is vulnerable to a correction as earnings deteriorate further. An economic recession is not in our forecast, but we will closely watch business investment and firms' hiring intentions, as firms could react to deteriorating profitability by cutting costs. Lower business capital expenditure (capex), or a rise in the unemployment rate could end the current economic expansion.

A boost in productivity growth could potentially help firms keep labour costs under control. However, given that labour shortages are likely to intensify, any productivity gains are likely to be muted. Alternatively, a scenario in which demand gets stronger, as in our global fiscal expansion scenario, could help US corporates limit the pressure on margins through higher price inflation. Finally, monetary stimulus could start coming through more strongly, helping to boost growth and prevent a profits recession from turning into a full economic recession.

 

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