07.16.18

Hot fun in the summertime for U.S. stocks—will corporate profits keep it going?

Brian Nick

The last week’s market highlights:

Quote of the week:

“Inflation is taxation without legislation.” – Milton Friedman
 
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Midyear Outlook:
  • U.S. economy: Running ahead of its peers.
  • Global economy: Trade a bigger concern outside the U.S.
  • Policy watch: Central banks aren’t all on the same wavelength.
  • Fixed income: Starting to prefer higher-quality assets.
  • Equities: Earnings are supporting prices, but expect plenty more volatility.
  • Asset allocation: Remain risk on, but focus on quality.

Equities: Expectations for earnings season likely to be met   

For the second consecutive quarter, corporate earnings growth is likely to exceed 20%, based on FactSet estimates. Such stellar profits have not come in back-to-back quarters for seven years. For the superstitious, both this quarter’s reporting season and the prior one unofficially kicked off on a Friday-the-13th. But analysts don’t appear to be worried about bad luck. Leading up to the first-quarter reporting season, they raised their earnings estimates by more than in any quarter on record, according to FactSet. And companies exceeded those expectations by nearly six percentage points, producing 24.8% earnings growth. With second-quarter earnings season just getting underway, analysts have once again refrained from their time-honored practice of lowering their forecasts before the numbers start to come in. 
With so much optimism, we wonder: do U.S. companies still have the ability to surprise on the upside, particularly amid growing trade-war fears?
For the second quarter, seven of the 11 sectors in the S&P 500 Index are expected to post double-digit earnings growth (according to FactSet). The Energy and Materials sectors appear poised to lead the pack with year-over-year growth estimates of 143% and 49%, respectively—largely thanks to the 50% increase in oil prices over the past year. Revenue growth should also be robust, with forecasts of a whopping 142% for Energy and 49% for Materials (versus 9% for the S&P 500 overall).
We’re also anticipating continued strong growth from Health Care, Information Technology, and Consumer Discretionary, all of which have generated healthy share price appreciation year to date. We’ll be watching to see if upside earnings surprises can continue to push stocks in these sectors higher, especially in Information Technology and Consumer Discretionary, which have already far outpaced the broader market this year.
On earnings calls, we’ll be listening for comments from company management about their plans to sustain, curtail, or cancel capital spending based on trade policy uncertainty. Last year’s tax breaks cut the average corporate rate by 9% and provided incentives for companies to frontload their investments in 2018. However, if companies encounter obstacles (e.g., tariffs) to U.S. economic growth, they may decide to hold onto their tax windfalls and hoard cash as they did for years after the 2008-2009 financial crisis.
The good news is that business investment appears to be on the rise again after several weak years. Survey data earlier this year showed an increase in the percentage of companies planning to undertake capital improvements. There is some evidence of a softening in those plans in recent months (which have been marked by tit-for-tat hikes in import taxes between the U.S. and its largest trading partners), but not yet enough to cause us to downgrade our growth outlook.
Ultimately, we believe that, net of taxes, corporate profits should post solidly double-digit growth this year and mid-to-high-single digit growth next year. But we are about to find out how vulnerable business sentiment is to trade protectionism. If companies downshift their plans to expand through investment, it could be a sign that this unusually long profits cycle is, indeed, in its later innings.

U.S. economy: Inflation jumps in June    

After June’s employment report showed continued tepid wage growth, markets focused on two key inflation releases last week to gauge the scope of inflationary pressure. The first, the Consumer Price Index, leaped 2.9% in June compared to a year ago. Although much of the past year’s acceleration was fueled by rising oil prices, even “core” inflation—which strips out food and energy costs—hit a six-year high of 2.3% in June.
The other inflation release was the producer price index (PPI), a measure of wholesale costs of goods and services. PPI surged 3.4% year-over-year in June—the fastest 12-month pace since 2011. This increase is consistent with regional Federal Reserve surveys, which show evidence of mounting price pressures on materials used in manufacturing. It also aligns with data from the Institute for Supply Management, whose manufacturing gauges have been signaling that supply constraints have become more acute.
It’s important to emphasize a few points about inflation. While taking Economics 101, many of us learned—a bit simply, perhaps—that inflation is the result of “too much money chasing too few goods.” For its part, the Federal Reserve broadly, albeit more technically, defines inflation as “a rise in the general level of prices, which results from growth in aggregate demand outpacing growth in aggregate supply.” For that reason, the Fed has not historically raised interest rates solely in response to import tariffs or a spike in oil prices, although both can lead to higher prices on various categories of goods and services.   
Longer-dated U.S. Treasuries largely ignored the solid inflation data. The yield on the bellwether 10-year note closed at 2.83% on July 13, after beginning the week at 2.82%. Meanwhile, the 2-year security, which is particularly sensitive to Fed policy, ended the week at 2.59%, up 6 basis points. Outside of the Treasury market, favorable technical conditions continued to support investment-grade corporate debt. After lagging all domestic fixed-income categories in the second quarter, the asset class has rallied in July amid declining supply.     
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
 
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