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Market View

The economic picture may be murky, but mild inflation and a more pro-business climate have been working for U.S. corporate earnings.

Economic forecasting is rarely easy.  Data are often “mixed,” with many caveats, and subject to differing interpretations.  U.S. economic reports over the last few months have been no exception. For example, a strengthening labor market counterbalanced by sluggish aggregate demand, as evidenced by the lower-than-expected reading on U.S. gross domestic product (GDP) for the first quarter released on April 28. 

Nowhere is that disconnect more apparent, in our view, than in the clear distinction between the middling direction of so-called “hard data,” based on actual measures of sales, production, and other economic activity, and the strength of “soft data,” which is derived from survey results (e.g., reports on consumer sentiment) and other indicators of expected economic activity. The gap between expectations and actual economic conditions is at a historically wide level, according to Morgan Stanley research cited in a recent Financial Times article.1 As an example of this divergence in recent times, Chart 1 shows the differing directions between a key measure of consumer sentiment and actual consumer spending. The heightened expectations evident in the “soft” data indicator may be attributable to the belief that changes to U.S. tax policy and business regulation under the new U.S. administration will spur faster growth—and higher wages—in the months and years to come.

 

Chart 1. Reports on the U.S. Consumer Illustrate the Gap Between "Hard" and "Soft" Data
Changes in indicated data series, January 1, 2012–December 31, 2016 (quarterly basis; latest available)

Source: FRED, Federal Reserve Bank of St. Louis (real personal consumption expenditures); University of Michigan, University of Michigan: Consumer Sentiment©, retrieved from FRED on April 30, 2017 (consumer sentiment).

 

The wide spread between current and expected economic conditions, while initially perplexing or even concerning to some observers, may in fact be a positive for corporate earnings—and, thus, for the equity market. Why? To answer, let’s first look at the implications of the “hard” data. The mixed numbers on U.S. economic growth indicate enough of an increase in activity to bolster the rate of inflation, but not to the point where GDP may accelerate and force the U.S. Federal Reserve (Fed) to step up the number and pace of interest-rate hikes.  Chart 2 shows that inflation expectations have increased firmly off the lows of last year, but not enough above the Fed’s expressed threshold of a 2% rate to cause alarm. In short, this is a “Goldilocks” scenario, an ideal situation when growth is neither too hot nor too cold.

 

Chart 2. Inflation Expectations Have Rebounded, but Not to Worrisome Levels
Five-year, five-year forward inflation expectation rate, April 27, 2012–April 26, 2017

Source: FRED, Federal Reserve Bank of St. Louis. The five-year, five-year forward inflation expectation rate is a measure of expected inflation (on average) over the five-year period that begins five years from the date of measurement.

 

The specter of deflation has faded—which is an important event, considering its impact on the slightly more aged and less dynamic European and Japanese economies.  The reduction of that deflationary risk has had a salutatory effect on commodity prices.  But persistently mild economic growth numbers have allowed interest rates to remain subdued, thereby bolstering housing markets around the world. 

The net result of this lukewarm economic picture is that earnings are finally picking up again (more on that below). In the past, we’ve noted that falling earnings don’t necessarily mean markets will suffer.  But, in the long term, the market needs earnings to grow to sustain—and expand—current stock valuations.  That is now happening.  As of April 28, 2017, we are just past the halfway point for first quarter earnings reports for S&P 500 companies, and the results have been encouraging.  According to FactSet, the blended earnings growth rate (a combination of actual results for companies that have reported and estimated results for companies yet to report) for the S&P 500® Index for the first quarter is 12.5%—the highest year-over-year earnings growth for the index since the third quarter of 2011. Earnings for the index are on a pace for the first year-over-year double-digit growth since the fourth quarter of 2011.2

Nearly 77% of companies which reported (through April 28) have beaten earnings per share (EPS) estimates so far, topping analysts’ consensus expectations by an average of 6.7% and posting EPS growth of 12.5% year over year.  Some highlights:

  1. Commodities have rebounded.  The energy and materials sectors were responsible for the majority of the earnings shortfall over the last two years of earnings declines.  In the first quarter of 2017, the energy sector rebounded from a year-ago loss, to post the largest contribution to S&P 500 earnings growth as a whole, while materials was up 16.8%.  Reduced exploration, cost-structure rationalization, and improving economic prospects have led to a textbook cyclical turnaround in the sector.
  2. Banks are starting to take risk again.  Earnings of companies in the financials sector are tracking up 19%, year over year.  Moderately increasing inflation expectations and interest rates have led to increasing net-interest margins at banks.  More important, banks are starting to trade again, boosting profits for major financial firms (though Goldman Sachs’s tepid first-quarter results stand as a notable exception).  While no major changes to U.S. financial regulation have been enacted, the anticipation of a less onerous regulatory environment appears to have encouraged trading activity.
  3. Information technology continues to grow at a double-digit rate. Sector earnings are up 15.8%, year over year, despite a strong U.S. dollar.  U.S.-based companies with a global footprint, including large tech firms, have learned to adapt cost structures and business practices to the dollar’s continued strength.
  4. A large majority of sectors are exceeding expectations. The expectations beats have been very broad-based among S&P 500 sectors, with only consumer staples and telecom reporting slight misses.
  5. The strength is starting with sales growth, but amplified through lean cost structures.  More companies (68%) are reporting actual sales above estimates, compared with the five-year average. Broad-based top-line growth is an excellent sign of the future, given U.S. companies’ efforts to reduce costs over the past several years; the leaner cost base increases earnings leverage.

Sluggish current U.S. growth, as exemplified by the “hard” data, has not slowed earnings, at least judging by the first-quarter numbers so far. What, then, do the expectations of faster growth evident in the “soft” data signal for equities? To be sure, the U.S. regulatory environment remains uncertain in the absence of a clearer view of how the new U.S. administration intends to implement promised changes.  That said, the risk is heavily weighted toward substantial regulatory easing rather than vice versa—which likely will be a tailwind for U.S. business activity. Couple that with the prospect of lower corporate tax rates under the White House’s proposed overhaul of the U.S. tax code, and it’s easy to see how anticipation of faster growth can push the “soft” data well ahead of actual economic measures. Such an environment may be supportive of expectations for U.S. corporate profit growth in the quarters ahead—a key input of equity valuations.

We believe that monitoring “hard” and “soft” data is useful when gauging underlying economic conditions for the U.S. equity market. But in our approach to active management, we remain focused on company-level fundamentals, along with the research and valuation disciplines critical to selecting those securities that can provide the best opportunities.

 

1Adam Samson, “Morgan Stanley Flags ’Record Gap‘ between Hard and Soft U.S. Data,” Financial Times, March 28, 2017.
2All earnings data referenced herein are from FactSet, as of April 28, 2017.

 

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