Sean Duffin
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
No, we don’t think investors should sweat the recent downgrades to global earnings forecasts. Although analysts have cut their expectations substantially since September, they still expect most regions to grow in the mid-single digits in 2019. Several factors—including the rapid acceleration in earnings growth in 2017 and 2018, the short-term boost of tax cuts, and record profit margins in certain markets and sectors—have propelled earnings to elevated levels, presenting a challenge to earnings growth going forward.
As equity market volatility spiked in fourth quarter, analysts began turning pessimistic on future earnings growth, slashing the earnings-per-share (EPS) outlook for calendar year 2019. Expectations have moved even lower to begin this year, and 2019 EPS growth estimates for global equities have dimmed from 10% to 6% since September 30. The United States shows a similar trend, with growth estimates downshifting from 11% to 5%. These declines in earnings estimates are not unusual; in fact, analysts revised global year-ahead earnings downward during each fourth quarter from 2010 through 2015 by an average of 2 percentage points.
Investors have questioned whether earnings this cycle have peaked in 2018, particularly in the United States. For third quarter 2018, US earnings grew 26% year-over-year, marking the ninth consecutive quarter of positive earnings growth and the fourth consecutive double-digit clip. Tax cuts provided a one-time boost to reported EPS growth in the United States but, even excluding that windfall, the United States likely still outpaced the growth of other developed peers in 2018. In calendar year 2019, most of these tax cuts will no longer provide a boost to earnings per share. At this point, investors must take “base effects” into consideration, as earnings growth has been running at an unsustainable pace for the last few years, and elevated 2018 levels will be a very tough comparable period for 2019 growth. These base effects are likely impacting near-term expectations, as analysts have recently estimated a 2.2% year-over-year decline in earnings growth for first quarter 2019. However, expectations point to a return to positive earnings growth through the remaining quarters of 2019.
While we are still quite early in the fourth quarter US reporting season, the proportion of companies that have beaten EPS estimates has slowed to multi-year lows, yet share-price reactions to even lackluster earnings results have been benign, with average price decreases of 0.3% surrounding negative earnings surprises. 1 These reactions may indicate that equity prices discounted an even worse fourth quarter outcome, and gives some credence to the “better than feared” narrative that some analysts have embraced during the equity rally at the beginning of the year.
Among global sectors, energy has seen the largest cuts—with 2019 year-over-year forecasts falling from 18% in September to just 0.3% in early February—reflecting the plunge in oil prices. Information technology also saw substantial downgrades, plummeting from 11% to -0.3%. All other sectors also saw downgrades, outside of the defensive utilities sector.
Even amid these recent downgrades, investors should not fret over a slowdown in earnings growth. A move to mid–single digit growth in 2019 would represent a downshift away from the heady recent pace, but could still support global equites. Since 1990, year-over-year earnings growth slowed in 17 calendar years, yet equites posted gains in 12 of those years. Moreover, global equities experienced single-digit earnings growth in five of those 17 years, averaging returns of 10% over those periods.
The combination of elevated earnings levels and profit margins, the fading year-over-year boost from the tax cuts, and slowing global growth all present headwinds to 2019 earnings growth. However, expectations for earnings growth still look relatively healthy at this point. A slowdown in earnings growth from inflated levels is not the same as an outright stall, and decelerating earnings growth does not necessarily imply negative equity performance. Additionally, equities have reacted mildly to fourth quarter earnings results thus far in 2019, highlighting that markets appear to have priced in even worse results. While geopolitical tensions and growth concerns loom large over the global economy, we don’t think investors should fixate on the recent slowdown in near-term earnings expectations.
Sean Duffin, Investment Director on Cambridge Associates’ Global Investment Research Team
Footnotes
- The average price increase is based on the average share-price change from two days prior to the announcement through two days subsequent to it, and was calculated by FactSet as of February 8, 2019. The five-year average price reaction to negative earnings results was -2.6% during comparable reporting windows.