Market Bulletin. 2Q18 earnings update: Tug of war. July 27, In brief. Politics vs. fundamentals
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1 Market Bulletin July 27, Q18 earnings update: Tug of war In brief 2018 has seen the stock market struggle to find direction, as political risks and robust earnings growth have offset one another, complicating the investment landscape. 2Q18 was another solid quarter for corporate profits, with financials, technology, and energy companies continuing to post impressive numbers. Healthy earnings, coupled with the repatriation of foreign profits, have left companies flush with cash. How they use that cash, however, is still in question. The yield curve is flattening, but not inverted. Although earnings growth will slow next year, there is still room for equity markets to grind higher before the cycle comes to an end. David M. Lebovitz Global Market Strategist Certain sectors and styles stand to benefit from tax reform more than others, suggesting an active approach to investing is warranted in the current environment. Politics vs. fundamentals Tyler J. Voigt Market Analyst The stock market is caught in a tug of war between politics and fundamentals. On the one hand, escalating trade tensions and the potential for additional tariffs suggest caution may be warranted; on the other, robust economic and profit growth support risk assets continuing to climb higher. So far the fundamental forces seem to be winning as evidenced by the S&P 500 s positive year-to-date return but the recent softening in confidence indicators, albeit from elevated levels, will be worth monitoring.
2 Against this turbulent policy backdrop, the 2Q18 earnings season is continuing the streak of healthy profit growth that began nearly two years ago. With approximately 62.6% of companies reporting, 84% are beating earnings estimates and 60% are beating sales estimates. Looking at a combination of reported earnings and analyst estimates, we forecast 2Q18 S&P 500 profits grew by 28% from a year prior. As shown in the Exhibit 1, many of the themes that dominated earnings announcements in the first quarter have continued a significant benefit to profits from tax reform, higher oil prices supporting energy sector earnings, and a weaker U.S. dollar benefitting those companies with healthy revenue generation outside the United States. In other words, the stars aligned once again for earnings in the second quarter. We estimate that tax reform is responsible for about 7%-pts. of the earnings growth seen in 2Q, while a weaker U.S. dollar and higher oil prices have contributed 3%-pts. and 1%-pts. respectively. Furthermore, profit margins look to have hit an alltime high of 11.8%, as low rates, still-weak wage growth, and lower taxes all provide a boost to profits. EXHIBIT 1: 2Q18 drivers of earnings growth Contribution to year-over-year % change 30% 25% 20% 15% 10% 5% 0% 9.9% 3.0% 1.0% 1.1% 6.0% 6.9% Revenue Oil USD Buybacks Margin Tax refrom impact 27.9% Earnings growth Source: Compustat, Federal Reserve System, NYMEX, Standard & Poor's, FactSet, J.P. Morgan Asset Management. Revenue and earnings growth estimates are based on J.P. Morgan Asset Management model and calculated using actual earnings and revenue for 62.6% of S&P 500 market cap and earnings and revenue estimates for the remaining companies. Oil and U.S. dollar contribution is based on regression analysis. Data are as of 7/26/2018. Cyclicals lead the charge The cyclical sectors are having another solid earnings season. Financials are benefitting from tax reform, higher rates, stable lending, and strong initial public offering and merger and acquisition (M&A) activity, but data on capital markets revenues is mixed. Furthermore, because some banks fumbled parts of the Federal Reserve s June stress test, their capital return plans have been put on hold. That said, a number of financial institutions have mentioned that in addition to any capital return plans, investment spending is set to accelerate as firms upgrade communications equipment and other technology. The more globally-exposed sectors technology, industrials and materials are also seeing another solid quarter of profit growth. These sectors in aggregate have benefitted from the -1.8% year-over-year decline in the U.S. dollar 1, but a weaker start to the year for the global economy could be an offsetting force. That said, early reports from the tech sector show that margins remain robust and buyback activity remains solid, providing an extra boost to the bottom line. Industrial companies continue to feel some pain from higher input prices, but an uptick in U.S. economic activity has boosted revenue growth and helped offset some of the downward pressure on margins. The energy sector continues to recover, and earnings seem to have more than doubled in the second quarter from a year prior. The average price of WTI oil was up over 40% in 2Q 2, which coupled with an uptick in shale drilling activity, has boosted energy company profitability. In fact, daily U.S. oil production is up 15.4% y/y, leading some energy companies to experience their highest profit margins in years. Additionally, after pulling back on capital spending in the aftermath of sharply lower oil prices in , those firms that are investing are using internal funding to do so, helping to keep leverage in check. 1 Based on the year-over-year change in the average quarterly value of the Federal Reserve s nominal broad effective exchange rate. 2 Based on the year-over-year change in the average quarterly WTI oil price. 2
3 How to spend all that cash? After paying taxes on foreign earnings at the end of last year, the beginning of 2018 has seen the first signs of repatriation. One obstacle to calculating how much cash has been brought back to the U.S. is that most companies don t report their cash balances by region. That said, the balance of payments data shed some light on this issue. The return on equity (or earnings) of foreign affiliates is typically comprised of cash that is repatriated to the U.S. parent company in the form of dividends and a portion that is reinvested in the foreign affiliate. When the value of this dividend exceeds current period earnings as it did in the first quarter this indicates repatriation 3. Based on our calculations, U.S. corporations repatriated about USD 200 billion in 1Q18. Importantly, it seems that most of this cash is held in U.S. dollars, making the impact on the currency somewhat negligible as this money comes back to the United States. This backdrop of robust profitability, coupled with the continued repatriation of foreign profits, begs the question of how these funds will be used. While there are early signs that some of this cash is being strategically deployed in the form of investment spending, we continue to expect that the majority of these funds will be used for buybacks, dividends, and M&A. Historically, there has been a lagged relationship between profit growth and capital spending as profit growth accelerates, companies become more confident in the outlook for demand, and subsequently increase investment spending in an effort to meet this expected demand. While profit growth has been quite strong, suggesting that a pick-up in capital spending may be imminent, there are offsetting political forces at work. The Federal Reserve's Beige Book which gathers anecdotal information about business conditions across the U.S. saw tariffs or trade policy 3 Bureau of Economic Analysis, June 20, mentioned 51 times in the July edition, up from only three mentions of trade-related uncertainty in March when tariffs were first announced 4. As such, despite certain instances where investment spending has picked up, it seems reasonable to expect that trade tensions may prevent the acceleration in capital expenditure that some expected at the beginning of this year. Furthermore, data on buybacks and M&A activity suggest that companies continue to focus on these areas, rather than investment spending, when it comes to deploying excess cash. Announced buybacks in 2018 are well above the average seen over the course of this cycle (Exhibit 2), and if M&A activity maintains its current pace through the end of 2018, it will hit its highest level in over fifteen years (Exhibit 3). Any softening in the trade situation could lead investment spending to accelerate, but with the nominal growth outlook still a bit uncertain, this feels like it would be the exception, rather than the rule. EXHIBIT 2: BENEFITS FROM TAX REFORM HAVE PROVIDED A SIGNIFICANT BOOST TO BUYBACKS S&P 500 announced buybacks, USD bn 2015 $700 $600 $500 $400 $300 $200 $ $0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: Bloomberg, Standard & Poor's, J.P. Morgan Asset Management. Based on company announcements. Data are as of 7/26/ Canally, John. U.S. Investment Strategy: Powell Tells All. BCA Research. July 23,
4 EXHIBIT 3: M&A IS ALSO POISED TO HAVE A RECORD YEAR Announced M&A transactions globally, USD bn $6 $5 $4 $3 $2 $1 $0 $3.0 Value of M&A deals announced 2018 estimate based on current pace $2.0 $1.6 $1.1 $1.2 $2.5 $4.2 $3.7 $2.4 $2.1 $2.1 $2.3 $2.0 $1.5 $5.2* $4.9 $4.7 $4.2 $3.8 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Source: Bloomberg, J.P. Morgan Asset Management. *2018 estimate is based on current pace of M&A through 7/26/2018. Data are as of 7/26/2018. Investment implications: Should I worry about the yield curve? Over time, stock prices follow earnings, and over the past eighteen months, earnings have been responsible for nearly all of the price appreciation we have seen in the S&P 500. Equities should be able to continue their upward ascent as long as corporate profits are growing, but with the pace of earnings expected to slow next year alongside a continued rise in rates, the return environment will become more challenging. Furthermore, the slope of the yield curve (as measured by the difference between 10-year U.S. Treasury yields and 2-year U.S. Treasury yields) is near its flattest level this cycle, leading investors to wonder whether a recession and end to this bull market may be lurking around the corner. Historically, an inverted yield curve has done a fairly good job of signaling recession. That said, massive central bank intervention since the financial crisis may have distorted the message coming from this indicator. Furthermore, inversion is the recession signal, rather that flattening, and once the yield curve does invert, it has been anywhere between six and eighteen months before the economy finds itself in recession. Finally, as shown in Exhibit 4, the equity EXHIBIT 4: THE S&P 500 USUALLY PEAKS ONLY AFTER THE YIELD CURVE INVERTS U.S. 10-yr. yield minus U.S. 2-yr. yield, % 3% 2% 1% 0% -1% -2% Yield curve S&P 500 peak Recession -3% '76 '79 '82 '85 '88 '91 '94 '97 '00 '03 '06 '09 '12 '15 '18 Source: Tullett Prebon, Federal Reserve System, Standard & Poor's, FactSet, J.P. Morgan Asset Management. The yield curve is measured by the difference between the 10-yr. U.S. treasury yield and 2-yr. U.S. treasury yield. S&P peak dates are 2/13/1980, 11/28/1980, 7/16/1990, 3/24/2000, 10/9/2007.Data are as of 7/26/2018 market tends to peak after the curve has inverted, not before. We acknowledge that the U.S. economy is late cycle, that the curve is flattening, and that politics are contributing to uncertainty. However, the U.S. economy looks set to continue growing at a 3% pace through the middle of next year, before decelerating in the back half of 2019 as fiscal stimulus fades and supply-side constraints take hold. This will impact the trajectory of earnings growth, and investors will need to adjust sector allocations accordingly. That said, the near-term environment of solid economic expansion and rising interest rates should provide support for equities broadly, and the more cyclical parts of the value index in particular. Trade fears and a stronger U.S. dollar have led investors to embrace small caps over large caps due to their more domestic orientation, but these companies could come under pressure if the U.S. dollar weakens in the back half of this year. At the end of the day, the tug of war between fundamentals and politics has not yet seen a clear winner; as a result, investors should be prepared for a bumpy ascent. 4
5 The Market Insights program provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients understand the markets and support investment decision-making, the program explores the implications of current economic data and changing market conditions. For the purposes of MiFID II, the JPM Market Insights and Portfolio Insights programmes are marketing communications and are not in scope for any MiFID II / MiFIR requirements specifically related to investment research. Furthermore, the J.P. Morgan Asset Management Market Insights and Portfolio Insights programmes, as non-independent research, have not been prepared in accordance with legal requirements designed to promote the independence of investment research, nor are they subject to any prohibition on dealing ahead of the dissemination of investment research. This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not a reliable indicator of current and future results. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority; in other European jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited (Co. Reg. No K), or JPMorgan Asset Management Real Assets (Singapore) Pte Ltd (Co. Reg. No E); in Taiwan by JPMorgan Asset Management (Taiwan) Limited; in Japan by JPMorgan Asset Management (Japan) Limited which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association, Type II Financial Instruments Firms Association and the Japan Securities Dealers Association and is regulated by the Financial Services Agency (registration number Kanto Local Finance Bureau (Financial Instruments Firm) No. 330 ); in Korea by JPMorgan Asset Management (Korea) Company Limited; in Australia to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 (Cth) by JPMorgan Asset Management (Australia) Limited (ABN ) (AFSL ); in Brazil by Banco J.P. Morgan S.A.; in Canada for institutional clients use only by JPMorgan Asset Management (Canada) Inc., and in the United States by JPMorgan Distribution Services Inc. and J.P. Morgan Institutional Investments, Inc., members of FINRA; and J.P. Morgan Investment Management Inc. In APAC, distribution is for Hong Kong, Taiwan, Japan and Singapore. For all other countries in APAC, to intended recipients only. Copyright 2018 JPMorgan Chase & Co. All rights reserved. MI-MB_2Q18EarningsUpdate 0903c02a822bebc4
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