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Corporate earnings in 2019: A fading momentum is in store!

The essential

After two years of strong earnings momentum, EPS growth is expected to decline considerably from 2019.

Between global growth reaching its climax, the fading impact of US tax reform, the declining contribution of oil and commodities and the rising wage costs and tariffs, the consensus is likely to be negatively surprised.

MSCI ACWI EPS growth which amounted to +17% in 2017 and is estimated at +16% in 2018, could fall to +7% in 2019, instead of +10% expected by the IBES consensus.

Although it is unlikely that market PE will rise in the latter part of the cycle, the prospect of a downgrading of consensus figures could weigh on the equity markets.

 

 

 

Flag-UK

 22 October 2018

 

 

 

 

Flag-FR

22 Octobre 2018

 

 

 

 

After two years of strong growth in earnings per share (respectively +17% and +16% for the MSCI ACWI according to the IBES consensus for 2017 and 2018), a sharp slowdown is in store for the year ahead in which that growth is expected to be limited to +7%. This normalisation of earnings is a result of the combination of two types of phenomena:

  • questions about global economic growth with the gradual tightening of monetary policies, less cash, and their corresponding foreign exchange crises on one side, and the rise of protectionism and its cascading effects on the other.
  • and high base effects, between the length of the recovery cycle, the mitigation of certain sector-specific effects, and the dissipation of the effects of American tax reform,

1) Questions about global growth…:

Global growth is still higher than potential growth… but increasingly marked with risks. Amundi’s central scenario forecasts 2019 global growth of 3.6%, slightly below the 2018 and 2017 figures (both +3.8%) but still higher than 2016 (+3.1%) and higher than potential growth, both in the United States and the Eurozone.

Given the protectionist itch, political risks (Midterms in the United States, Brexit, European elections, etc.) and the weakening of an increasing number of emerging economies (South Africa, Argentina, Turkey, Venezuela, etc.), this forecast is nonetheless likely to be revised downward.

Barring a major external shock (geopolitical blow-up, oil price spike, financial crash, etc.) these revisions would be assumed to be limited, at around 20 basis points for example). However, they may be combined with fresh bouts of weakness in emerging currencies, which in return would also affect the profit dynamic of developed markets.

 

2)...and high base effects…:

A lengthy cycle. The weight of the United States is considerable within the MSCI World AC (55.5% of the index’s cap), but the recovery in the US is already very old. In total, by the end of September 2018, it had gone on for no less than one hundred and eleven months since its low point in June 2009, making it the second-longest cycle of the thirty-three observed since 1857!

While US EPS have already rebounded +147% since their low of December 2009 and are 77% above their pre-crisis level of December 2007, their additional growth potential is definitely real, but appears constrained nonetheless.

Likewise, six years after coming into effect, through reforms and a massive depreciation of the yen, Abenomics have largely reinvigorated Japanese EPS. As for EPS in emerging markets or the Eurozone, their growth margins seem more within reach. But in reality, that growth is expected to remain hindered due to a less favourable economic environment (see chart 1).

1/MSCI indices, EPS base 100 on 31/12/2007

After a huge rebound, a limited additional potential for US EPS

Corporate-earnings-Fig1

 

The economic slowdown should remain controlled… but we are more dubious regarding Earnings growth.

Non-reproducible sectoral effects. The very large increase in earnings over the past eighteen months is a result not just of the positive effects of the global economy and U.S. tax reform, but also very pronounced, non-reproducible sectoral effects. For instance, although the earnings of the MSCI World AC grew +17% in 2017, Energy and Base Materials contributed to 33% of the rebound even though they only made up 12% of the index. This performance is not, however, sustainable.

Over that recent period, Energy benefited simultaneously from both the rise in oil prices (+33% on average in 2018 for Brent after +22% in 2017) and the decrease in provisions recorded in 2015-2016 after the collapse in oil prices. After nearly doubling in 2017, then growing more than 50% in 2018, earnings in the sector are now expected to stabilise in the two years ahead.

Likewise, earnings from Base Materials, which were enormous in 2017 (+41%) and are still expected to rise nearly 20% this year, should greatly slow down in the future due to the decline in the price of numerous commodities as a result of questions regarding the fluctuations and components of emerging growth in general, and in China in particular (see chart 2).

2/MSCI World AC: Contribution to Earnings growth by sector

Energy and Materials should run out of steam

Corporate-earnings-Fig2

The system is close to being balanced today.

The dissipation of the effects of tax reform. In September 2017, Donald Trump announced a tax reform that included a cut in the business tax rate and encouraged share buybacks. This reform came into effect in early 2018 and had a massive effect on the EPS growth of American companies. In retrospect, we can observe that 2018 EPS growth was revised from +11.3% same time last year to +23.5% today! In the meantime, the growth in US GDP for 2018 was revised from +2.0% to +2.9%, but the effective US dollar exchange rate rose +10% over the same period of time, which dragged down earnings. In other words, between stronger GDP growth but a less favourable exchange rate, most of the upward revision of 2018 EPS is therefore due to tax reform… hence its effects are likely to vanish next year… (see chart 3)

3/US EPS growth overtime

The brisk accelaration of 2018 is due to the tax reform

Corporate-earnings-Fig3

Sectoral and fiscal effects poised to dissipate…

3) …will drag down 2019 earnings:

The erosion of top line growth (see §1) combined with the dissipation of the tax and sectoral effects mentioned above (see §2) and the increase in labour costs and tariffs will have a clearly negative effect on 2019 EPS growth. The table below summarises the impact of these various factors both in the United States and worldwide (with or without the U.S.). 2019 EPS growth is likely to fall from +23% in 2018 to +8% in the United States, from +16% to +7% worldwide, and from +10% to +6% outside the United States (ACWI ex-USA), or by 2 to 3 points, i.e. 20 to 30%, below consensus expectations.

Corporate-earnings-Fig4

Earnings growth could end-up 20% to 30% below consensus

Regarding top line fluctuation in the equities markets (consolidated revenue), the expected deceleration of global growth should be reflected in sales volume. Given that many of a company’s costs are not directly linked to its business volume, such as rent, insurance, depreciation of fixed assets, and a large share of its wages, the impact of a decline in volumes on EPS is estimated to be -0.8% for the MSCI USA and -1.3% for the MSCI ACWI. This impact may of course inch higher or lower depending on additional criteria like changes in corporate pricing power and foreign exchange rates. Companies’ price elasticity, meanwhile, seems to be neutral at best given the slight deceleration expected in final demand. Likewise, on the foreign exchange front, after its strong appreciation in 2018, the effective exchange rate of the U.S. $ is expected to stabilise over the year ahead.

The dissipation of the base effects of tax reform. In the United States, this will unquestionably be the most important decline factor for 2019 EPS. Although this had bolstered earnings growth in 2018 by more than 12% (23.5% - 11.3% = 12.2%), in the opposite direction, its end is expected to cut earnings by nearly 10% in 2019, assuming a 10% residual effect from the tax reform stemming from a lasting effect on share buybacks. Furthermore, given the weight of the MSCI US within the MSCI ACWI, the dissipation of American tax impacts will have an impact around 5% on global EPS.

The normalisation of oil prices is also expected to hamper the growth of both the MSCI USA and the ACWI. Thus, in the United States, the rise in oil prices in 2018 (+33% on average since 1 January for WTI) and the drastic decline in provisions should propel earnings in the sector by +97%, a contribution of nearly 15% to the increase in EPS for the MSCI USA as a whole, from a sector that counts for only 6%. On the other hand, current oil prices, boosted by supply bottlenecks and geopolitical factors, do not seem sustainable according to most observers. Along the same lines, Amundi’s forecasts for the average price of oil next year ($68 for WTI and $75 for Brent) are substantially below the latest spot prices ($76 for WTI and $86 for Brent) and very close to the averages observed since the start of the year ($67 for WTI and $73 for Brent). Against this backdrop, the growth in the sector’s earnings could fall to +3% compared to the +27% expected by consensus, which, all other things being equal, would take 1.4% away from US EPS growth. Note that even taking the higher end of our forecasts for a barrel of WTI ($75), MSCI US earnings would still be 0.5% lower than consensus expectations. Worldwide, a comparable simulation suggests a 1.0% decline in the 2019 EPS growth of the MSCI ACWI. Additionally, the increase built into the price of oil with the end of the 12- and 24-month hedges (respectively $68 and $60 instead of a spot price of more than $80 for Brent currently) will continue to drag down numerous transverse sectors, from basic chemistry at one end to air or shipping transport at the other.

If, on the contrary, oil prices defy expectations and rise much higher due to supply-side attrition, this would evidently benefit earnings in the oil sector... but this would ultimately be negative for profits as a whole, given the impact it would have on global economic growth.

 

Rises in wage costs. Further along in the recovery cycle than most other countries, the United States has nearly reached full employment, and corporate earnings are at a multi-year high. In this environment, the rise in wage costs, which is a lagging indicator, is expected to end up accelerating and would therefore drag down the rise in 2019 MSCI USA earnings. After an average of +2.5% in 2017, the total Employment Cost Index or ECI (see chart), which includes wages on the one hand and benefits on the other, grew +2.8% for the first six months of 2018. Up to now, US employers have preferred to emphasise variable components, such as bonuses rather than wages. Given the foreseeable deceleration in the economy, this bias is expected to endure. Regardless, the total ECI index’s growth could accelerate by around +3.2% next year, which would lead to an increase in direct costs (share of wages in the company’s added value) and indirect costs (share of wages in corporate inputs) of employment equal to 0.3% of revenue, or -1.9% of EPS. In the rest of the world, changes in payroll costs will remain highly variable from country to country, depending on development, legislation, and the business cycle. For simplicity’s sake, we have chosen a neutral trend. However, as the United States accounts for 55.5% of the MSCI ACWI, the impact on that index will be -1.0% (see chart 4).

4/US Employment Cost Index (ECI) for Civil Workers

A delayed indicator which is poised to rise now

Corporate-earnings-Fig5

Very moderate for a long time, wage costs will end up weighing.

Rising tariffs. As to the impact of rising tariffs on 2019 EPS, in the absence of clear signs regarding Europe and Japan, the focus will be on bilateral trade between the United States and China. The United States began taxing $34 billion worth of Chinese imports at 25% beginning 6 July, then a second $16 billion segment beginning 23 August. Later, a third wave of $200 billion was taxed at 10% beginning 24 September; this rate will rise to 25% beginning on 1 January. For its own part, China replied to the first two waves with equivalent rates, amounts, and schedules. Next, it announced a third wave of 5 to 10% taxes on $60 billion worth of goods, also beginning 24 September. All other things being equal, in 2019 these additional tariffs cloud represent a +$52bn surcharge on American imports from China and +$11bn on Chinese imports from the United States. Partially absorbed by consumers (American in the case of Chinese exports, and vice versa) and partially by producers (in China, in the case of Chinese exports, and vice versa), this surcharge is expected to reduce American EPS by 1.4% and MSCI ACWI EPS by 1.2%.

Conclusion

After their substantial increase since late 2016, EPS growth is expected to greatly decline beginning in 2019. Besides reaching the peak of economic growth and the gradual tightening of monetary policies, there are also numerous factors like the dissipation of the impact of American tax reform, the reduced contribution of oil, the increase in labour costs, and the impact of tariffs. Against this backdrop, it is likely that the consensus will continue to revise its expectations downward. As in 2018, most markets experienced derating even as their earnings grew respectably, this pressure could endure next year, all the more so if Earnings disappoint and Interest rates rise…

If earnings growth disappoints, Investors could worry

 

 

WANE Ibra , Equity Strategy
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Corporate earnings in 2019: A fading momentum is in store!
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