Weekly Update: It's all about earnings

04-07-2017

Amid very low volatility—the VIX had its lowest average quarter since Q4 2006—the S&P 500 is off to its best start to a year since 2013 and its third best since 2000. When the S&P returns 5% or more in Q1, as was the case this year, returns the rest of the year typically skew to the upside. Stocks are now entering what historically have been their 2 seasonally strongest months, supported by what is expected to be a solid Q1 earnings season. As of March 31, S&P Capital IQ’s consensus estimate for operating earnings-per-share (EPS) was up almost 10% on a year-over-year (y/y) basis. That would represent the third consecutive quarter the S&P posted y/y EPS increases after 4 successive declines, and would take 12-month EPS to a new record high. But the focus is on the better environment for revenue, aided by recent improvements in corporate pricing power and inflation beyond just oil-base effects. U.S. wage growth is among the highest in the cycle; ISM prices paid is at its highest since 2011; and NFIB intentions to raise prices have moved to elevated levels. In Europe, the capacity utilization rate is now above the cycle average and the unemployment rate has fully unwound the recessionary downturn. This has EPS momentum on its first global synchronized upswing since 2009. Consensus EPS revisions are not following the usual pattern of downgrades so far this year, with U.S. EPS revisions breaking into positive territory and emerging-market EPS revisions also moving higher. Credit conditions are supportive, high-yield spreads are well behaved and equities remain under-owned, with corporations via buybacks the only consistent buyer over the last 10 years.

Extremely transparent monetary policy (more below) should keep skittishness muted and the rally going through spring. While talk of “sell in May” is likely to grow, Strategas Research notes seasonal weakness is most pronounced in late summer/early fall. The recent pullback removed a lot of the post-election optimism, making for a nice contrarian positive—Investor Intelligence bulls have fallen below 50% from a multi-decade high of 63% in February, while the AAII weekly survey shows only 30% of investors identifying themselves as bullish, down from 50% in Q4. Also, Fundstrat’s proprietary internal momentum indicators are turning favorable: it says a lengthy list of stocks that peaked in mid-December are now deep into 3-month corrections and close to oversold levels. The main worry really doesn’t have anything to do with Washington, but instead concerns growth. Treasury prices have climbed meaningfully of late and the yield curve is flattening—the 2/10 spread is close to hitting multi-month tights. The Atlanta Fed’s GDPNow forecast now stands at 0.6% for Q1, well below the consensus of around 2%. Because the forecast changes as the data flows in, the regional Fed finds itself in the center of the debate over soft and hard data, i.e., bullish sentiment surveys vs. disappointing actual results such as this morning’s jobs report (more below). With two weeks until Q1 reporting season gets underway, it’s the quiet period and corporations can’t purchase their shares, meaning there’ll be a significant lack of support for share prices if disappointing economic or political news triggers market weakness.

One concern is margin compression. Ex-financial margins have shrunk considerably from their Q3 2014 peak, resuming their contraction in Q4 after stabilizing somewhat earlier in 2016. A tightening labor market is the main culprit and corporate tax cuts could help, but their status is unclear in a Washington where even President Trump’s own staff reportedly is struggling to unite around a strategy. Analysts don't seem to have raised post-election 2018 estimates to account for tax reform, and 2017 revisions and growth estimates are reflective of the current state of the economy and corporate profits, not what could be. Jeffries says the current 2-year forward P/E multiple is 16.3 and that a 25% tax rate with no change to deductions could boost S&P earnings to roughly $165 next year, well above the $145 consensus, putting the multiple at 14.3—below the 2-year forward average of 14.7. Even if the tax-reform blueprint pivots to a less ambitious plan, JPMorgan calculates there will be upside for earnings and equity values. It estimates a tax rate of 27.5% that excludes the highly controversial border-adjustment tax would add $8 to EPS. A more conservative scenario with a tax cut half that size could increase EPS $4. Further, if multinationals were to onshore some $1 trillion of foreign cash, it estimates that would add another $1.30 to EPS. This week’s buzz has been about Russia, Syria, missile strikes, bond yields, parsing the Fed’s minutes. Noise. It’s all about earnings.

Positives

Jobs weren’t as bad as the headline While March nonfarm payrolls didn’t even break 100K, there were signs it could be a one-off. Miserable weather appears to have disrupted the survey week, while the month’s 10-year history suggests there are seasonal adjustment issues. The separate household survey (used to calculate the jobless rate) soared by nearly 500K, lifting its Q1 monthly average to 296K. Moreover, the jobless rate ticked down to 4.5%, wage growth remained near cycle highs and Q1 payrolls averaged a still robust 178K even with today’s disappointment. Other reports this week were strong: ADP private payrolls jumped a well-above consensus 263K as a post-election surge in business confidence (the Conference Board’s quarterly CEO gauge hit a 12-year high in Q1) seems to be translating into more jobs. Also, online help-wanted ads rebounded, already low jobless claims trended further down and Challenger job cuts, on a 12-month average basis, fell to a 19-year low.

Handoff to manufacturing from services growth The manufacturing ISM slipped in March but remained at an elevated level, with the share of expanding industries matching a 13-year high and new orders growing faster than inventories a fourth straight month, setting up inventory replenishment as a growth driver for Q2. Markit’s final tally on the month wasn’t as robust but still reflected expanding factory activity. Elsewhere, February capital goods orders rose a strong 2.8%, another sign capital expenditures are on the rise. Construction spending jumped to an 11-year high, with residential activity lifting y/y growth to 3% despite an 8% y/y decline in public construction spending. And February’s trade deficit narrowed sharply, a positive for Q1 GDP.

Manufacturing strong globally as well The global manufacturing PMI is holding at its highest level in nearly 7 years and has been in expansion territory 51 of the past 52 months, with component readings suggesting more upside is likely. Growth trends continued to broaden, with the share of expanding individual-country PMIs at a 3-year high and the percentage of countries with PMIs above year-ago levels also near a 3-year high.

Negatives

Autos intensify ‘hard’ vs. ‘soft’ data debate Even as consumer confidence danced around multi-decade highs, March auto sales significantly disappointed, falling to their lowest annual rate in 2 years despite the richest incentives since the industry was navigating the financial crisis in 2009. This year’s year-to-date drop-off after 2016’s steady rise suggests Q1 consumer spending will be soft. However, the current sales rate of 16.6 million is high relative to long-term fundamentals. Goldman Sachs’ analysis of scrappage rates, population growth, licensed drivers and vehicle ownership puts trend demand for autos ex-cyclical fluctuations at 15 million units per year. And the trend of more and more young people finding they don’t need a car likely will continue to weigh on demand.

Handoff from services to manufacturing growth For much of the past 2 years, the nation’s service sector was humming while manufacturing was stumbling. Now the shoe may be on the other foot, as the March non-manufacturing ISM fell to its lowest level in 5 months while Markit’s services PMI fell to its lowest level in 6 months. Both remain expansionary but momentum has been weakening on slowing new orders. This drop-off was reflected in March service payrolls, which slowed dramatically.

Fed becomes less of a friend Minutes from the March meeting suggest the Fed is likely to hike again in June and perhaps September before moving on to begin paring its massive balance sheet by year-end. Perhaps the most surprising element was that the central bank will look at phasing out both Treasury and mortgage-backed security (MBS) reinvestments—the thinking had been MBS would be addressed first. The market reaction to these moves toward policy normalization was muted even if the message was clear: the tightening cycle is here to stay.

What else

Fewer immigrants and babies is a problem With the pace of immigration—both legal and illegal—already slowing down comes word the U.S. fertility rate has fallen to 1.85 births per women, its lowest level since the Centers for Disease Control started keeping records in 1909. It takes at 2.1 births per woman to maintain a stable population, and the U.S. has been below that replacement rate since 1972. Fewer births and fewer immigrants represent a long-term structural issue for the labor market and for U.S. businesses.

This gender gap favors women Artificial intelligence (AI) is obsoleting human jobs at an alarming pace and men are suffering disproportionately. For example, BCA Research notes the livelihood of truck drivers—95% of whom are men—is likely to be destroyed in coming years by the increasing use of autonomous and semi-autonomous vehicles. On the other hand, education, human health and social work sectors that have seen the strongest job gains over the past two decades and aren’t really vulnerable to AI predominately employ women. With AI in its infancy, this established pattern of job destruction and creation should continue to favor women over men. 

The Easter Bunny’s going to need a bigger bag A lot of small businesses have been ringing up Easter-related sales in record numbers. The National Retail Federation estimates this will be the biggest Easter sales year ever, with consumers on track to spending $18.4 billion prior to Easter Sunday.