The stock market rally in the New Year has barely lifted the gloom over earnings outlook–as we enter the reporting season. Analysts have aggressively cut their forecasts, yet we see some potential for more earnings downgrades. Why? The economic cycle is moving into its late stage, adding to worries about slower growth and rising pressure on corporate profit margins. This argues for more carefully balancing risk and reward in portfolios.
Sentiment on corporate earnings
The pessimism on corporate earnings is palpable. Sentiment is the weakest since mid-2016, as suggested by the earnings revisions ratio (or ERR, the number of analysts upgrades versus downgrades). The ratio for global companies at the start of January is about a quarter lower than the historical average ahead of fourth-quarter earnings seasons. The ERR and equity performance have tended to move in lockstep historically, with negative earnings sentiment associated with falling stock prices, and vice versa. See the chart above. We see some potential for more downgrades, although the ERR is nearing past trough levels outside of recessions. Globally, earnings per share (EPS) are expected to grow 6.6% in 2019, versus 14.9% in 2018, according to consensus estimates. The decline in earnings expectations for U.S. stocks is even starker: EPS growth for 2019 is estimated at 6.7%, down from 23.9% in 2018. U.S. earnings are coming off a “sugar high” that was boosted by with 2018’s fiscal stimulus and tax cuts.
Challenges in 2019
Corporate earnings are becoming harder to forecast as the economic cycle ages. Rising worries about slower global growth, elevated risks around U.S.-China trade conflicts and other hot-button geopolitical issues are likely to lead to increased earnings volatility in the first half of 2019. We may see large swings in prices in reaction to earnings surprises.
One key to watch in earnings releases: sales guidance. It peaked in early 2018 with rising corporate confidence in global growth, and has trended lower ever since. Some early indicators of corporate sentiment, such as the Duke CFO Global Business Outlook, suggest companies have become more concerned about their firms’ financial prospects–and global growth. Yet it’s not all doom and gloom. We still see solid, albeit slowing, global growth in 2019, and view the near-term risk of a U.S. recession as low even as the U.S. economic cycle enters late-stage. The Federal Reserve is likely to put its rate increases on hold until the second half of the year, boding well for risk assets, we believe. More stimulus in China and Europe could potentially provide further support for stocks and other risk assets. Another plus: more attractive equity valuations after last year’s selloff. Consider the U.S. market: Valuations have dropped to around 15 times forward earnings, down from nearly 19 a year earlier.
We believe equities can post positive returns this year, but heightened levels of uncertainty should cap valuations. We prefer quality companies with strong free cash flows and clean balance sheets, and the U.S. over other developed markets. Healthcare is among our favored sectors. We like emerging market equities after a big derating in 2018. And we see a growing role for bonds as portfolio diversifiers as the maturing cycle brings the potential for more frequent risk-off episodes.