Testing Times for Corporate Profits
We are about to enter the Q3 reporting season for US corporate profits against a backdrop of faster-than-expected deceleration in global economic growth. The International Monetary Fund (IMF) is almost certain to revise down its economic growth forecasts for both 2012 and 2013 when it shortly releases its World Economic Outlook. Developments in China and the eurozone have weighed heavily on the performance of the global economy. Meanwhile, deceleration in emerging markets has also taken its toll on growth expectations. Small wonder why we are confronted with the most serious growth slowdown since the end of the Great Recession.
Elevated levels of US corporate profitability are partly attributable to the recovery of the financial sector and strong foreign-sourced profits. Domestic non-financial corporate profits are also elevated, although they are not at all-time highs. Given the likelihood of further deceleration in global growth, it is important to gauge the current state of earnings expectations for Q3 and Q4 in order to anticipate how the US equity market may react to profit results.
Current Q3 S&P500 Earnings Expectations
The latest expected Q3 EPS growth for the S&P500 is -2.6%, implying $25.01 per share. This growth rate has been revised down from +1.9% at the end of June. The materials, information technology and energy sectors have largely been responsible for the downward revision to Q3’s growth rate. The only sector to experience an upward revision to its growth rate is financials. If current earnings expectations are fulfilled, it would mark the end of eleven consecutive quarters of positive earnings growth for the S&P500.
Five of the ten S&P500 GIC sectors are expected to register negative EPS growth in Q3, led by energy (-21.4%) and materials (-20.1%). The declines in EPS for these two sectors come despite higher commodity prices during Q3 versus Q2. With the notable exception of oil prices, however, many average commodity prices for Q3 are below their year-ago levels. This partly helps to explain the expected declines in both top and bottom-line performance for these sectors.
Financials are expected to register the strongest EPS growth during Q3 (+10.4%). AIG and Goldman Sachs will supposedly be the strongest contributors, partly due to weak results a year ago. The third tranche of quantitative easing by the Fed should support the financial results of the sector moving forward. The Fed has extended the mortgage carry trade into 2015 in its bid to persuade banks to extend further credit to the private sector.
Continued Weakness in Top-Line Performance?
One of the salient features of the Q2 S&P500 reporting season was the large incidence of companies missing top-line estimates. Expected top-line growth for the S&P500 for Q3 currently stands at zero. This has been revised from +1.9% at the start of Q3. Once again, the sources of downward revisions to top-line performance have been the materials, information technology and energy sectors.
Eight of the ten S&P500 GIC sectors are expected to register positive top-line growth. Energy (-16.7%) and materials (-3.1%) are the only sectors expected to register negative top-line growth. The energy sector is, by far, the biggest drag on aggregate top-line growth: excluding energy, expected Q3 S&P500 top-line growth would be +3.4%. With the exception of financials, the S&P500 GIC sectors are expected to register higher top-line growth vis-à-vis bottom-line.
What about Guidance?
One of the major reasons for the downward revisions to Q3 corporate profit expectations was a high incidence of negative guidance issued by S&P500 companies. Of the 103 S&P500 companies offering any semblance of guidance for Q3, the overwhelming majority (80%) was negative. September was a very quiet month for guidance. There were only 9 cases of S&P500 companies offering any guidance for Q4 (all negative).
S&P500 EPS Recovery Still Expected in Q4
Changes in earnings expectations have historically lagged changes in the real economy. The faster-than-expected deceleration in the global economy has only belatedly impacted earnings expectations for Q4 and 2013 H1. Although growth rates have been revised down since the end of June, a recovery in S&P500 EPS growth from Q3’s supposed nadir is still widely expected. EPS growth is expected to recover to +9.4% in Q4. This has been revised down from +13.8% at the end of June. Meanwhile, S&P500 EPS growth is expected to be +5.5% in 2013 Q1 and +9.6% in Q2. These 2013 H1 growth rates have been revised down from +7.4% and +14.2%, respectively at the end of June.
US Macroeconomic Uncertainties Remain Formidable
The macroeconomic backdrop against which earnings expectations are being formulated embraces elevated uncertainty. In the US, we have the lingering uncertainty about the magnitude of potential fiscal tightening in 2013. The Fed’s inception of a third tranche of quantitative easing will help to blunt some of the effects of fiscal policy tightening. Housing is clearly being targeted by the Fed. The aim is to encourage banks to engage in more mortgage lending. The future path of US house prices will be an important factor in determining whether the policy goal will be achieved: continued improvement in home prices should improve the quality of banks’ collateral, thereby potentially encouraging easier lending terms.
Foreign Woes to Continue in Q3
I recently argued that the Fed would try to justify any further expansion of its balance on domestic factors. The Fed did exactly that by placing a greater weight on reducing elevated unemployment as a policy goal when it invoked the third tranche of quantitative easing. Foreign events have, however, also been steadily mounting as headwinds for the US economy and corporate sector during 2012.
Reports of economic weakness outside of the US became much more prominent during Q2. Given further signs of weakness in Europe and emerging markets (most notably China), we should expect S&P500 companies with significant exposure to allude to continued softness in these markets. The US dollar exchange rate should, however, be less of a headwind in Q3 than Q2: the trade weighted dollar against major trading partners peaked towards the end of June. This is consistent with the timing of the rally in US equity prices, as markets increasingly discounted the inception of further quantitative easing by the Fed.
Stay Focussed on China
We should expect companies to continue to cite caution about the outlook in Europe. Meanwhile, we still see continuing signs of deceleration in China’s economy: the growth rate of profits at China’s industrial companies continued to contract in August. Although still at double-digit levels, top-line growth at China’s industrial firms also continues to moderate. Economic growth slowed to 7.6% in Q2. The declining growth of revenue and profits at Chinese industrial companies in Q3 would be consistent with even slower economic growth figures.
The impending change in political leadership in China has partly been blamed for the apparent lack of new initiatives to spur economic growth. The uncertainty about China’s attitude towards further stimulus will not be cleared until the new Standing Committee assumes power. Historically, a change in the Standing Committee has been associated with a surge in credit growth. Will history repeat itself? The new Standing Committee assumes power on 8 November. Recent political events would suggest that “get rich quick” capitalism (synonymous with the disgraced Bo Xilai) will not be embraced with the same ardour. It may imply that the new Standing Committee will not be in a hurry to approve more rapid credit expansion. Stay tuned.
US Equity Valuation and Q3 Earnings
As we enter the Q3 reporting season, the 12-month forward P/E ratio for S&P500 is 12.8. This compares to a ten-year prior average of 14.3. The recovery in corporate profitability since the end of the Great Recession has, for the most part, not imparted richer valuations to equities as an asset class. Since the end of June, however, we have witnessed some modest P/E multiple expansion. In order to return to the prior 10-year average, we probably need a combination of lower 12-month forward earnings expectations and higher stock prices. Achieving this outcome when discount rates are so low is not easy: lower 12-month forward earnings expectations could potentially test the credibility of expected long-term earnings growth.
The conclusion should be simple: P/E multiple expansion in Q3 came courtesy of the market discounting the Fed’s decision to invoke a third tranche of quantitative easing. Exposure to the riskiest component of the capital structure was made more appealing by the reduced perceived risks to the economic and profits outlook. The problem is that quantitative easing is potentially suffering diminishing returns: more aggressive balance sheet expansion is now required to produce the same effects as earlier tranches of quantitative easing.
Summary and Conclusions
The global economy slowed further in Q3, particularly outside of the US. The deceleration in the global economy provides a challenging backdrop for US corporate profits, particularly since foreign-sourced profits are a major factor behind elevated levels of profitability.
Q3 operating S&P500 EPS is now expected to decline on a year-over-year basis after eleven consecutive quarters of increases. Expectations have been scaled back since the end of June. Energy and materials are expected to register the weakest growth in Q3, while the financial sector is expected to be the strongest for EPS growth.
Top-line weakness, so prevalent in Q2, is expected to continue in Q3, although the bulk of the weakness appears to be in energy and materials (despite higher commodity prices). September was a quiet month for guidance. Those issuing guidance for Q4 were all negative.
A recovery in S&P500 EPS growth is still expected in Q4 and 2013 H1, although the magnitude of the increases have been scaled back to incorporate a more challenging global macroeconomic outlook.
China’s outlook is particularly uncertain, given impending political changes. The attitude of the incoming Standing Committee to boosting credit growth remains unclear. The arrival of a new credit boom, normally associated with a new Standing Committee, is not yet guaranteed.
The US equity market enjoyed some modest P/E multiple expansion in Q3, largely courtesy of the market discounting the arrival of the third tranche of quantitative easing. A return to the P/E valuations of the prior 10-years would require a combination of rising equity prices and falling earnings expectations. This is a tough task with discount rates at such low levels and quantitative easing having seemingly lost some of its earlier novelty.
Leave a Reply