U.S. stock indexes have rallied to new highs in recent weeks. The S&P 500 is up roughly 25% since its December low, fueled partly by encouraging first-quarter earnings results. What does this mean for our view of U.S. equities? We still favor them, as cost-cutting and efficiency gains help moderate the earnings slowdown.
U.S. corporate profit margins are holding up, despite rising concerns that today’s low unemployment rate could spur labor shortages — and wage inflation. Attention to these trends is reflected in our text-mining analysis of broker reports from 2004 to 2019. We found the share of reports that carry the phrase “margin pressure” is now below the historical average, even as the share of documents with the phrase “tight labor” is at all-time highs. See the chart above. How to explain this apparent disconnect? Companies have been using technology to drive efficiencies that keep costs down, reduce the need for labor and help keep profit margins stable. See the “automation” line in the chart, which reflects this trend. To be sure, the pressure on earnings is likely to intensify in this late-cycle period as wage inflation picks up and productivity growth slows. Yet for now, companies are taking actions to cushion the downside, with many also returning capital to shareholders through share buybacks.
A better (but not great) earnings picture
U.S. earnings growth has slowed sharply from the double-digit pace of 2018. First-quarter earnings are up just 2.3% from a year earlier based on the companies that have reported to date, representing 80% of the S&P 500 market capitalization. Ahead of this earnings season, consensus estimates were pointing to a modest year-on-year contraction, the worst quarter for S&P 500 earnings growth since the second quarter of 2016. Companies have been beating forecasts at a higher rate than previous quarters, as subdued analyst expectations had lowered the bar for U.S. earnings beats. Earnings also appear solid when viewed in the context of slowing global economic growth and the fading impacts of U.S. fiscal stimulus. Yet we are still seeing more downgrades to analyst earnings expectations than upgrades this quarter, even as the pace of downgrades has eased over the last four weeks. Any bottoming out of earnings expectations could support a market that has rallied aggressively this year.
Some of the biggest drags to results appear to be diminishing for cyclical and resource sectors. Consider the improving Chinese economy and incremental progress in U.S.-China trade talks. The latter, along with dovish Fed expectations, contributed to markets recently reaching record highs. Yet sentiment does not appear ebullient, and the ability of companies to generate decent earnings growth despite a slowing economy speaks to their ability to drive efficiencies. Meanwhile, China could be a further boon to earnings growth. We expect a turnaround in Chinese growth from the second quarter.
There are risks to our outlook.
Trade tensions could intensify again. And market expectations for Fed rate cuts are too dovish, in our view, meaning the Fed is less likely to provide additional support to equities. Not all sectors are created equal. Analysts expect expanding margins this year in the technology, health care and consumer discretionary sectors, while they see margins of defensive sectors more challenged. Finally, market punishments for misses have been more severe than in previous quarters, with low tolerance for poor results at this late-cycle stage. Yet here’s our bottom line: First-quarter earnings have confirmed a better earnings picture than expected, supporting our near-term preference for U.S. equities.