US equities. Earnings boom despite market gloom

Transcription

1 Earnings boom despite market gloom Chief Investment Office Americas, Wealth Management 12 April :59 pm BST Jeremy Zirin, CFA, Head of Investment Strategy Americas, David Lefkowitz, CFA, Senior Equity Strategist Americas, Edmund Tran, Equity Strategist Americas, While the US equity markets have seen a surge in volatility, the first 1 correction in two years and roughly flat yearto-date returns, corporate earnings trends remain robust. Tax reform is providing a significant boost to profits this year, but even excluding tax benefits, trends remain very solid. We expect S&P 500 EPS to rise by 2 in the first quarter 12% excluding tax benefits with revenues increasing by 7%. We maintain our full-year 2018 S&P 500 EPS estimate of USD 154 (16% growth) and 2019 estimate of USD 162 (5% growth) for Strong current profit growth is largely a reflection of favorable economic conditions. Healthy business confidence and still-low financing costs are boosting business spending on investments and labor. In turn, this is boosting consumer confidence and driving consistent gains in consumer spending. In our view, recent equity market volatility reflects concerns that 1) rising inflation could drive a faster pace of Fed rate hikes, 2) trade disputes may escalate and materially weaken global growth, and 3) return prospects for mega-cap technology stocks the market darling of the past few years may be vulnerable due to elevated valuations and increased regulations. Ultimately, we do not believe that any of these risks will derail the bull market, but markets will likely remain volatile (both to the upside and downside) over the next several weeks given the confluence of these unresolved issues. We maintain our constructive outlook on global equities (of which, the US comprises roughly 5 of the global benchmark) versus government bonds. US equity valuations have becoming increasingly attractive during 2018 given the combination of sharply positive forward-looking earnings revisions and flattish stock prices. The S&P 500 P/E (on forward 12m EPS) now stands at 16.4x the lowest level in 18 months and down from 18.3x at the beginning of the year. Fig. 1: Earnings growth remains solid S&P 500 EPS, in USD E 2019E Source: FactSet, UBS, as of 11 April 2018 Fig. 2: Stocks seem to be ignoring solid corporate fundamentals S&P 500 price index and next-12-months consensus EPS estimates S&P 500 (left) S&P 500 NTM EPS (right) Source: FactSet, as of 11 April 2018 Economic growth remains solid... While market volatility has significantly increased over the past three months, economic fundamentals remain very solid. Consumer and business confidence are robust (Fig. 3), the US labor market is healthy initial claims for unemployment insurance are near five decade lows, banks are easing credit availability a good leading indicator for profit growth (Fig. 4), and orders for new business equipment are very solid. (Continued on next page) This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the document.

2 In fact, economic data has consistently been better than expected (Fig. 5). The tax cut package that was enacted in late December 2017 only strengthens the near-term growth outlook. As a result, our economics team forecasts real GDP growth of 2.8% in 2018 and 3. in 2019, the strongest two year period of growth since supporting robust earnings growth Based on the strong economic momentum, we expect full year 2018 EPS of USD 154 (16% growth). This includes roughly an 8% boost from tax reform. For 2019, we are sticking with our estimate of USD 162 (5% growth). This estimate may prove to be a bit conservative. When we introduced the 2019 estimate we had assumed that the benefits of tax reform would begin to erode as competition whittled away at the tax windfall. But trends have been a bit stronger than we expected. For instance, forward revenue revisions have been steadily rising (Fig. 6). Second order effects from the tax cut (increased economic growth) could be stronger than anticipated. As we collect more data on corporate profit trends during first quarter earnings season, we will revise our estimates as appropriate. Fastest EPS growth since 2010 in 1Q Results for the first quarter earnings season should reflect these solid trends and may provide markets a much sought after respite from all of the wrangling over global trade. We look for revenue growth of 7% in 1Q18, one of the strongest growth rates in the last six years. Earnings growth should be even more impressive, and will likely reach 2 (the fastest since 2010 Q4). As mentioned, this quarter will be the first that incorporates the tax reform legislation that was enacted on 22 December and includes a steep reduction in the corporate tax rate. Still, even without tax reform benefits, we estimate EPS growth will be ~12%, a very healthy number. Bear in mind that S&P 500 profits have a different composition relative to the broader US economy. The S&P 500 has more exposure to tech, energy, and financials. So, profit growth should be even stronger than economic growth, in part due to rebounding profits from a low base for energy (which is expected to see an % surge in earnings), rising interest rates and tax reform boosting financial profits (>2 growth), and continued above-average EPS growth in tech (>2 growth). Overall, growth should be fairly broad-based in the first quarter, with the median company in the S&P 500 delivering EPS growth of 18%. All sectors should grow at least 8%. Non- US revenues are also about a third of the total whereas, exports are only ~1 of GDP. With the weakness in the US dollar, the positive currency tailwind should boost earnings growth by 1-2%. Encouraging results from early reporters The "early reporters" reflect some of these trends. Twenty-three companies generally those that have fiscal quarters that ended in February have already announced results for the first quarter. While still a small sample size, results from these companies have been encouraging. Historically, only about half of companies exceed sales estimates and roughly two-thirds of companies beat earnings estimates. This quarter, the percent of reporters beating on sales and earnings is coming in at 63% and 78%, respectively. Perhaps more telling, the magnitude of the beats have been well above historical norms. Sales are beating by 4.3% and earnings are 8.7% Fig. 3: Business and consumer sentiment is near multi-year highs Small business optimism and consumer sentiment indices NFIB Small Business Optimism Index (left) Univ. of Michigan Consumer Sentiment Index (right) Source: Bloomberg, UBS, as of 11 April 2018 Fig. 4: Credit availability supports earnings Bank lending standards and S&P 500 EPS growth % Credit standards easing -4 Credit standards tightening -% S&P 500 EPS y/y (left) Senior loan officer survey (right, inverted, advanced 9m) Source: Bloomberg, UBS, as of 11 April 2018 Fig. 5: Economic data has been better than expected UBS US growth surprise index Note: rising (falling) line = inflation data is higher (lower) than expected. Source: Bloomberg, UBS as of 11 April Chief Investment Office Americas, Wealth Management 12 April

3 better-than-expected compared to the historical average beats of approximately 0-1% (sales) and 3% (EPS). Based on results from Accenture and Adobe, IT spending trends remain robust, driven by healthy adoption of digital services. Continued growth in cloud computing platforms is spurring growth for Red Hat. Micron (semiconductors) is also benefiting as datacenter demand increases. Outside of tech, FedEx posted solid results for the quarter and has capitalized on the strong demand. And despite the highest mortgage rates in four years, housing demand remains solid. Order volumes from KB Home and Lennar were better than expected. However, in consumer-oriented segments of the market, trends were more mixed. While end demand remains solid, several companies have cited some inflation pressures. Darden Restaurants cited increased labor costs, while Conagra Brands and General Mills called out higher transportation costs. A more balanced outlook for the tech sector Despite solid earnings trends in tech, we reduced our allocation to a neutral, or a "benchmark" weight on 22 March. We are not negative on tech. Instead we view the risk / reward for the sector as balanced, especially in light of the increase in the sector's relative valuation over the last few years. After years of trading at a valuation discount to the market, tech now trades at a 1 premium. This is in line with its long term average. In addition, while earnings growth for the sector remains solid, it is no longer materially "outgrowing" other sectors. Many non-tech sectors derive greater benefits from tax reform and are benefiting even more from a broad-based pickup in industrial and consumer activity. Our preferred sectors are energy (low valuation), financials (benefits from rising interest rates, economic growth and deregulation), and materials (benefits from global industrial activity). What's weighing on markets? Over the last two months, market volatility has significantly increased and investors appear to be largely ignoring these stronger profit trends. As we show in Fig. 2 (page 1), there has been a noticeable disconnect between corporate profits and stock prices. Markets recorded their first big daily decline in this correction on 2 February when the Department of Labor reported that wages grew at the fastest pace in nine years. Since then, the market has been very sensitive to faster than expected inflation readings. Investors seem to be concerned that inflation has reached an inflection point and will begin to rise much faster than expected (Fig. 7), forcing the Fed to raise interest rates more aggressively which could lead to a sharp slowdown in the economy. The situation is compounded by the fact that tax cuts and greater government spending are boosting growth at a time when inflation is already beginning to firm. We think some perspective is warranted. There are still strong deflationary forces at work. Globalization has not stopped, information technology continues to make businesses and consumers more efficient, and there is substantial capacity in commodity markets. So while inflation is firming from low levels, we believe this is a return to a more normal inflation environment rather than the onset of an "inflation problem" for markets (Fig. 8). Fig. 6: Broad-based improvement in sales outlook Percent of analyst forward revenue estimate changes that are positive (negative), S&P 500 constituents 15% 1 5% -5% -1-15% Source: DataStream, UBS as of 11 April 2018 Fig. 7: Inflation has been higher than expected recently - reversing weak readings in 2017 UBS US inflation surprise index Note: rising (falling) line = inflation data is higher (lower) than expected. Source: Bloomberg, UBS as of 11 April 2018 Chief Investment Office Americas, Wealth Management 12 April

4 Trade war unlikely The rhetoric around trade and tariffs has also been a source of volatility. However keep in mind that most of this appears to be negotiating tactics. For instance, despite president Trump's public disdain for NAFTA, the negotiations between the US, Mexico and Canada appear to be going well and an agreement looks to be within reach that would make some small changes to the original compact. Also bear in mind that the tariffs that have been announced so far are exceedingly small and should have a minimal economic impact. While we cannot rule out the risk of a serious escalation in trade frictions, this risk may be lower than the market's perception. Markets can rise even if tech is not leading Lastly, there seems to be some concern about the health of the tech sector, which accounts for 25% of the S&P 500. As we highlighted above, the outlook for the sector looks slightly less attractive to us than it did a few months ago, especially relative to other sectors. But fundamentals remain solid. Concerns about regulatory risk may linger, but this risk only impacts a subset of the tech sector (mostly social media) and any changes in the business model for tech companies likely won t substantially alter the trajectory for cash flow growth for the sector. While the tech sector has been a market leader in recent quarters, the fundamentals for other more economically-sensitive sectors are improving. So even if tech doesn't outperform, the broad-based earnings strength across several sectors should power further equity market gains. Hard to pick the bottom, but risk / reward looks compelling In our view, while the sources of market volatility over the past few weeks may linger, ultimately we expect them to be resolved with a benign or market-friendly outcome over our six month tactical time horizon. Robust earnings trends should continue and drive stock prices higher. That being said, while we expect equity market returns to be solid this year, returns may not keep pace with earnings growth. In other words, valuation multiples will likely compress a bit this year a normal occurrence when earnings growth is as robust as it is. Nonetheless, with the forward P/E for the S&P 500 now the lowest in 18 months (Fig. 9), it looks poised to rise from current levels and the risk / reward for the US stock market is attractive. We remain overweight global equities relative to government bonds. Fig. 8: Inflation should remain fairly stable Change in US core Personal Consumption Expenditures prices, year-over-year; diamond denotes forecast 12% 1 8% 6% 4% 2% -2% Source: Bloomberg, UBS as of 11 April 2018 Fig. 9: Valuations are back to late-2016 levels S&P 500 next-12-months P/E ratio 19x 18x 17x 16x 15x 14x 13x 12x 11x 10x Source: FactSet, UBS, as of 11 April 2018 Chief Investment Office Americas, Wealth Management 12 April

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