Q1 earnings forecasts: a low bar for outperformance or a reason for caution?

Expectations for earnings growth has been revised steadily lower for the upcoming quarter. Operating earnings estimates for the S&P 500 back in August of 2018 were around $41.00, but the turmoil of the fourth quarter (Q4) of 2018 saw this figure revised downwards, with the pace of downward revisions only easing in February this year. Now operating earnings are expected to be $36.70, a decline of 10.4%.

Downward revision for Q1

Downward revisions to earnings forecasts are nothing new, and indeed are a part of the pre-earnings season ritual that is seen each time.

In Q1 2018, operating earnings for the S&P 500 were $36.54, so a figure of $36.70 would represent almost no growth whatsoever. Despite the worries, Q4 2018 still saw steady year-on-year growth, as did Q3 2018. Q4 2018 saw the first drop in US corporate profits since Q1 2017, and came off the six consecutive quarters of growth, but overall corporate profits have been climbing since the beginning of 2016.

The last serious drop in US corporate profitability came in late 2014, with the fall in energy prices driving down performance for big oil firms and hurting the S&P 500 overall.

What will the impact of US GDP growth slowdown be?

The slowdown in US gross domestic product (GDP) growth will have an impact. Profits tend to follow GDP, and with just 2.1% growth forecast for Q1 2019 according to the Atlanta Fed GDPNow model, a slowdown in profits should be expected.

Operating earnings had grown steadily since Q4 2016, while sales had risen since Q3 2017. A period of moderation for both now looks highly likely. Trade wars, Brexit, slowdowns in key parts of the global economy such as Europe and Japan and the diminishing effect of US President Donald Trump's tax cuts, will all play their part in weakening performance this time around.

A full-blown earnings recession is not yet on the cards, but it is something to be aware of. A decline in corporate profitability removes one key prop of the valuation case for equities. While the S&P 500 saw a drop in its valuation during the late 2018 sell-off, a recovery has been seen over the past four months. It remains to be seen whether investors will still look to buy equities in an environment of declining profitability, even in a world where bonds offer such low yields.