The earnings picture is getting complicated.
As earnings season kicks off Friday, investors are debating the impact of an unusually large number of variables, including higher rates, higher raw material costs, weaker foreign currencies, tariffs and weaker demand from China.
One thing’s for sure, investor attention is focusing away from third- and fourth-quarter earnings (both of which will be outstanding) and toward 2019 projections.
Let’s look at the major issues.
1. Margin erosion. This is principally about higher costs in wages and raw materials. Amazon‘s announcement of a $15 minimum wage will not affect third- or fourth-quarter earnings, but it has everyone scrambling to figure out what the impact might be in 2019.
The good news on higher costs is that many companies are trying to pass them on to customers with price increases.
There’s one other saving grace to keep margins up, and that’s higher revenue. The S&P is seeing revenue growth this year close to 9 percent, well above the average of the last few years, and will likely see growth of about 7 percent in 2019.
Q1: 8.4 percent
Q2: 9.5 percent
Q3: 7.4 percent
Q4: 6.6 percent
Q1 2019: 6.6 percent
Source: Thomson Reuters
“If we have strong sales, that tells me that margins are going to remain strong,” Earnings Scout’s Nick Raich told CNBC.
Keeping revenue growth strong is thus crucial to the stock outlook going into 2019. “If interest rates are in fact permanently higher, then organic earnings growth (driven by revenues) must rise or valuations will fall,” DataTrek’s Nicholas Colas wrote recently. “That’s the cruel simplicity of equity valuation math.”
2. Tariffs. Skeptics are fond of scoffing at the tariff effect, claiming that in the overall grand scheme, tariffs are not material to any but a few companies. It’s true. Few companies so far have stated that earnings would be falling specifically due to tariffs, but many are dropping hints.
In an earnings call on Sept. 20, Micron CFO David Zinsner said: “We expect gross margins to remain very healthy in the fiscal first quarter, although lower than fourth-quarter levels, and our gross margins will also be impacted in the near term by the announced 10 percent tariff on $200 billion of imports from China, which will go into effect on September 24. We are working to gradually mitigate most of the impact from these tariffs over the next three to four quarters.”
The concern is that skeptics are likely underestimating the impact of a full-blown trade war with China. Goldman Sachs, using conservative assumptions, recently estimated that a 25 percent tariff on all imports from China would cause S&P 500 2019 earnings to drop to an estimated $159 a share from $170, which would essentially mean 2019 earnings would be flat compared with 2018.
3. Higher interest rates. Goldman also noted that “rising yields should weigh on firms with the heaviest debt load, as higher rates flow through to higher interest costs.”
What’s it all mean? For many, the risk/reward ratio still favors stocks: “My bottom line is to stay long stocks,” Raich said. “When the economy is strong, stock prices will typically climb higher than the fundamentals suggest. That’s what happened in 2000 and 2007.”