Earnings Outlook: Earnings Growth Has Flatlined

Summary

• Equities capitalized on improved labour market news to claw back much of the August selloff.
• We continue to expect the (Federal Reserve) Fed will err on the side of dovishness and avoiding a hard landing, making a major selloff unlikely.
• But earnings growth has flatlined for the S&P 500 and declined for NASDAQ 100, and that funk shows little sign of abating. We expect equities to trade in a narrow range, with little prospect of the rally resuming until earnings show signs of rising again.
• It will be a quiet week, with only 14 mostly small companies reporting and no major economic news.

Market Implications

• We still like to be tactically underweight in the homebuilder ETF XHB. It rallied last week with the broader market and a 30bp drop in 2Y Treasury yields. But the 10Y Treasury yield reversed a rally and fell only 5bp.
• We expect further pressure on longer-term yields, and on the XHB ETF.

What We Learned Last Week

Equities managed to shake off just over one-half of August losses last week. Incoming data seemed to suggest that stresses in the economy are easing. The 3.7% drop in JOLTS release of job openings (versus expectations of little change) was particularly welcome, along with a slightly slower-than-expected read on GDP and steady inflation.

Does this mean the Fed will stay on hold rather than raise rates another notch?

Fed Still Dovish – We think the Fed will raise rates again before yearend unless there is a clear improvement in inflation. We also think the Fed will retain a dovish bias, in that Fed Funds will remain well below the level implied by the Taylor rule, and that it will err on the side of adjusting policy to maintain the recovery. The Fed does not want to engineer a hard landing to stop inflation.

As long as markets believe that, we think a major selloff in equities is unlikely unless there is some major new shock.

Earnings on Hold – But equities will also continue to trade in a narrow range for the foreseeable future due to a lack of earnings growth. Trailing and forward earnings for the S&P 500 (SPX) have been flat for the past year (Chart 1) and falling for the NASDAQ 100 (NDX) (Chart 2).

It is difficult to see how either index can maintain a rally if earnings growth has stalled. When SPX earnings hit a lull during 2015-17, the SPX simply traded in a narrow range until earnings expectations started rising again. The earnings lull was less pronounced for NDX, but it too traded in a narrow range for much of 2015.

Earnings have posted solid beats of 7.7% for SPX and 10.4% for NDX, but these are against very conservative expectations. The top-level earnings in Charts 1 and 2 do not lie – earnings are not rising. Investors have mostly ignored reported earnings – their focus has been primarily on outlooks, and companies that disappoint here have seen their stock prices drop by 5-10%. Even if many companies offer conservative guidance to report a beat in the next quarter, the emerging picture is that earnings are not set to grow.

Homebuilder Underweight – We still like to be tactically underweight in the homebuilder EFT XHB. It recovered last week on a 30bp drop in the 2Y Treasury yield to 4.88%. But the key 10Y Treasury yield ended the week only 5bp lower at 4.18%, after initially dropping 20bp. We expect continued upward pressure on longer-term yields, which will also keep pressure on homebuilders.

The Week Ahead

Between the holiday and a seasonal lull, only 14 companies report this week, and only about 30 report throughout September. Most companies reporting this week are small Russell 1000 companies. The only major company report is grocer Kroger (KR) on Friday.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)