Q4 US earnings season: a tougher time for equities?

Quarter four (Q4) earnings season, coming as it does after a violent downward move in equities in the US, promises to be an interesting one. Depending on your view, it is either a great opportunity to long equities, or the moment to reinforce your bearish view. In the former case, it will remind investors that companies are still seeing strong growth in earnings (although perhaps not as strong as in previous quarters), but in the latter it will send a signal that earnings growth is slowing and that tougher times ahead are expected.

Earnings are expected to rise 15% over the year, which is slower than the 30% seen in quater three (Q3), but still healthy growth, and the fifth consecutive period of double-digit growth. These are impressive numbers, and not to be dismissed.

But earnings reports are not about the past. They are also about the future, and whether the outlook is encouraging or not. The global outlook looks quite different from a year ago, when ‘synchronised global growth’ was the cry.

The official Chinese manufacturing purchasing managers index (PMI) has moved into contraction, while growth in Europe is slowing too, and the US cannot remain immune to all this. It already looks as if things are getting tougher, as the five regional US Federal Reserve (Fed) indices of manufacturing fall in unison. This has not happened since the first half of 2016. Particularly worrying however has been recent weakness in the Institute of Supply Management's (ISM) manufacturing report, and this weakness is beginning to feed through into confidence and job hiring, despite the robust 300K+ print in non-farm payrolls for December and the healthy rise in wages seen at the same time.

Thus, the outlook for the current quarter may not be particularly rosy. Quarter one (Q1) earnings, according to Reuters, are expected to rise around 3.9%, a noticeable slowdown from Q4 of 2018. Even if the figure improves, it still has a long way to go in order to begin providing a more optimistic picture.

Earnings will also have been depressed by the fall in oil prices. From 2014 until the beginning of 2016, overall profit margins for the S&P 500 fell from 10.1% to 8% as oil prices fell. A similar hit to performance for energy stocks should be expected this time around. While oil has recovered somewhat, there is still a lot of ground to be made up.

The positive element of the S&P 500’s drop is that valuations are now much less stretched than a few months ago. The index’s forward earnings multiple is around 15, compared to 17 in the middle of 2018 and 18+ in the first months of the year.

Stocks are now cheaper, and while the more difficult outlook might justify this valuation, it also means that earnings surprises are now more likely, providing an upside boost to equities. But if the outlook for the current quarter and into the rest of 2019 is fairly gloomy, the downward move of late 2018 may resume. This quarter, perhaps, is the most crucial for equities in quite some time.