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U.S. earnings season kicks off in earnest Friday with JPMorgan, Wells Fargo and Citigroup reporting quarterly results. Growth expectations, thanks to tax reform and a strengthening global economy, are lofty; Goldman Sachs, for instance, expects S&P 500 profits to be up 17 per cent year over year.

Many investors are counting on that earnings growth to fuel further gains in equity markets, but the risk of disappointment is rising. Bullish profit expectations may already be baked into many stock prices. Meanwhile, economic and inflationary trends indicate further challenges to sustainable market rallies as 2018 unfolds.

Morgan Stanley strategists Andrew Sheets and Michael Wilson are among those viewing this earnings season in a much darker light than the expected profit growth would suggest. While noting that strong bottom-line results will likely be a short term catalyst for stock prices, they believe rising inflation pressure and slowing economic growth represent a “tricky hand-off” for markets for the rest of the year.

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In essence, Morgan Stanley is strongly suggesting that the coming earnings season will be as good as it gets for equity investors in 2018.

“Many of the things we expected this year are happening – higher volatility across [interest] rates, [foreign exchange] and equity markets, tighter financial conditions, … contracting equity valuations in the U.S., narrower breadth and a peak in economic leading indicators and data surprises,” Mr. Wilson wrote in a March 25 report.

In a late February CNBC interview, Mr. Sheets emphasized that tax policy was already reflected in equity prices and earnings estimates, raising the odds of disappointment in terms of actual profit results or future guidance. Goldman Sachs equity strategist David Kostin echoed this view on April 6, writing, “the downside risk for sales and [earnings-per-share] misses is substantial.”

The the chart below highlights the jump in S&P earnings-a-share expectations for the first quarter. Optimism has been climbing throughout this year, despite market volatility, with profit forecasts jumping 13.3 per cent. The biggest upward adjustment occurred at the end of March as consensus earnings-a-share estimates for the benchmark were revised upward by 7.6 per cent.

The upbeat profit expectations raise the risk of a “buy the rumour, sell the news” market pattern. This would a reaction in which prices may not climb substantially, or might even fall, if expectations are merely met. As Mr. Kostin indicated, the market punishment for missing higher profit estimates could be severe.

Morgan Stanley’s Mr. Sheets, to be clear, is not bearish about earnings season – it’s the rest of the year he’s worried about.

The strategist points to global purchasing manufacturers surveys to support his contention of slowing economic growth. These surveys ask prominent manufacturing executives to answer questions regarding business activity, hiring expectations and orders for new products in order to measure growth in the industry.

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The JPMorgan Global Manufacturing PMI index, shown in the second chart, combines these survey results from across the globe. The chart shows year-over-year change in the survey, which indicates that while global economic growth remains positive, the pace of acceleration has weakened. The year-over-year improvement in the manufacturinsecg survey actually peaked in February, 2017, and has since been drifting lower toward zero, or no improvement.

Morgan Stanley also believes inflation pressure will limit equity gains later this year. The strategists use the yield on the U.S. 10-year inflation-indexed note – which shows the yield on the 10-year Treasury bond minus the rate of inflation (bottom chart) – as a gauge to longer term inflation expectations. They believe the yield on the note will break higher this year, above the zero-to-80-basis-point range it’s been in since 2013.

Economists agree that inflation expectations are important for economic growth and asset values but the degree of importance is hotly debated. For investors, it’s far more clear cut – real 10-year yields are vital to portfolios because they are used as a discount rate to value equities.

In discounted cash flow calculations, the discount rate is used to determine the present value of future earnings, dividends and cash flow for a given company. This forms a baseline value for the company’s stock. As the discount rate (in this case inflation-adjusted 10-year yields) rises, the value of future cash flows and stock prices both decline.

The market’s reaction to coming U.S. profit reports will, in my opinion, all come down to corporate guidance on full calendar-year earnings. Bottom line results should be terrific, but if slowing global economic growth and rising inflation expectations are reflected in lower than expected profit guidance for the rest of the year, the mood of investors could sour in a hurry.

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