With quarterly earnings season set to begin in earnest, the outlook for corporate profit growth has suddenly weakened.
Amid signs that the global economy could slip into a synchronized slowdown, earnings estimates for 2018′s fourth quarter and for 2019 have been revised down sharply in recent weeks, raising doubts over one of the market’s key sources of strength.
Several large U.S. banks will release their fourth-quarter earnings this week, and markets will be looking for growth signals in financial results and in management comments about the year ahead.
“This earnings season is going to be really important,” said Jason Mann, chief investment officer of Toronto-based Edgehill Partners. “Is this trade war really starting to bite, are we seeing any weakness in the consumer, are companies talking about laying people off?”
Those questions took on some urgency after U.S. stocks suffered through their worst month of December in nearly 90 years, crushing investor sentiment around the world.
As the main U.S. stock indexes piled up losses, dropping close to 20 per cent from their September peaks up to Christmas Eve, analysts were also cutting their earnings forecasts.
For companies in the Standard and Poor’s 500 index, total fourth-quarter earnings growth is now expected to be 14.5 per cent, according to data provided by Refinitiv. While that’s still relatively high, it’s down from an estimate of 20.1 per cent just three months ago – part of an earnings surge fueled by U.S. corporate tax cuts.
Corporate Canada has been hit with a similar downgrade, with S&P/TSX Composite Index earnings growth expected to come in at 4.3 per cent for the fourth quarter. At the start of October, that estimate sat at 12.9 per cent.
The silver lining to such a dramatic reduction in profit expectations is that it makes for a much lower hurdle for companies to clear. Beating the consensus estimate is often handsomely rewarded by the market, though last earnings season seemed to buck that tradition.
With sentiment softening in early October, and with equity valuations high relative to history, investors soundly punished the stocks of companies that missed third-quarter earnings projections, while largely ignoring those that beat forecasts..
“In Canada, every company that missed even by a little bit just got killed,” Mr. Mann said. “I think this quarter, it’s going to be the opposite.”
This time around, the market has more of a valuation cushion. Over the last three months, the price-to-earnings ratio on U.S. large-cap stocks has declined by more than 15 per cent.
As for Canadian stocks, investor sentiment is so low relative to history that they are arguably less susceptible to negative earnings reports.
“Resource stocks are completely bombed out,” said Martin Roberge, a portfolio strategist at Canaccord Genuity. An index that tracks TSX-listed materials stocks lost nearly 9.3 per cent last year; one that tracks Canadian energy shares lost more than 26 per cent.
Despite the very real possibility of further downward revisions to Canadian earnings, “cheap valuations on resource and non-resource cyclicals overrides TSX [earnings] risk,” Mr. Roberge wrote in a note.
Beyond the fourth quarter, the corporate sector’s outlook for the year ahead will be closely watched for signs of growth vulnerability.
Apple Inc. set a discouraging precedent on that front earlier this month, when it cut its revenue forecast for the first time in nearly 20 years, citing weak demand in China. That stoked fears of a broad slowdown in the Chinese economy.
For the entire S&P 500, earnings for 2019 are expected to grow by 6.4 per cent, which is down from 10.2 at the start of the fourth quarter.
“I think that many analysts are still too bullish in their outlooks for 2019,” said John Zechner, president of Toronto-based wealth management company J. Zechner Associates.
“I expect the news to remain bleak on earnings and the economy in the year ahead and that will be the tougher test for stocks in 2019.”
The other possibility is that the recent softening of corporate profits and economic activity represents a pullback to a slower pace of growth, rather than an outright contraction. In that case, it’s plausible that the market has already corrected enough.
"I don’t think we’re going to see a broad-based deterioration in earnings,” said Ed Perks, chief investment officer of the multi-asset solutions group at Franklin Templeton Investments, citing the strength of the U.S. consumer as a continuing driver of economic growth.
“Hearing banks talk about the consumer appetite for loans is going to be an important starting point,” he said.