JUNE 2019

Revisiting Earnings and Earnings Multiples as Drivers of the Equity Markets

Category: Investment Research, Managing Directors, Managing Partners, Portfolio Management

By Doug Cohen, Managing Director, Portfolio Management

I began the year with a “20 Questions” (and Answers) market overview that covered the issues I believed would be most pertinent to capital markets over the balance of 2019. I promised to revisit those issues over the course of the year. This month I return to the two variables that, by definition, determine equity prices: earnings and earnings multiples.

Question number eight on the original list was, “Will S&P 500 earnings exceed the current 8% consensus forecast in 2019?” I gave this a 35% Probability. My conclusion can be read here.

Five months later, the earnings per share (EPS) trajectory is playing out much as we anticipated. Exceeding the original 8% hurdle still seems highly unlikely, but the probability of an outright earnings recession has declined. With nearly all US companies having reported, 1Q19 earnings were better than expected. Whereas by late March the consensus had come to expect outright EPS contraction in the first quarter, actual operating EPS came in at nearly 5%. Approximately 75% of US companies exceeded EPS expectations, on par with averages over the past few years. Encouragingly, top-line growth also rose about 5% in the US, despite the modest deceleration in the global economy during the quarter.

So much for the rearview mirror though—the equity market is most focused on the trajectory of earnings revisions. Here the news is more mixed as revisions for 2019 were generally negative, even as revisions for 2020 were slightly positive. The negative trajectory for 2019 isn’t shocking in that consensus analyst earnings estimates typically fall over the first 3-6 months of the year before companies surpass the lower bar, enabling the full-year actual earnings to exceed the mid-year forecast. Still, the decline in expectations for the remaining quarters of 2019 has been more pronounced than normal. As a result, the current consensus for full year 2019 US EPS growth is just under 3%, implying a moderate slowdown from the 1Q19 pace.

Of course, much can still change over the balance of the year given trade tensions and many other risks. For example, while our full 20 Questions report made the case for a slightly weaker US dollar in 2019, the trade-weighted greenback is up about 2% year to date—a net negative for US earnings given that over 40% of US operating earnings come from overseas. As we noted early in the original 20 Questions report, the Fed is unlikely to raise rates this year which, at the margin, should prevent a major upside move in the dollar. On the other hand, until the last two weeks or so we also strongly disagreed with the prevailing 75% expectation implied by the futures market that the Fed is likely to cut rates by year-end—something that, all else equal, would tend to weaken the dollar. Our view had been that most of the year to date economic data had been, in Goldilocks terms, more or less “just right” (e.g., 2%-plus GDP, 2%-minus inflation, and 2-ish interest rates—a scenario we coined “deuces running wild”). This scenario strengthens the Fed’s position to resist political pressure from President Trump and others to reduce rates, while staying true to what I think is its dominant desire—remaining on the course to normalization so as to have ample ammunition to reduce rates when the next major slowdown materializes.

To be clear, I still believe that the aforementioned “deuces running wild” outcome is the most likely one, potentially enabling the Fed to stay on hold through year-end. However, based on the generally gloomy global economic data released over the past two weeks that extended from China to Europe to the US (where the domestic manufacturing Purchasing Managers Index fell to a nine-year low), the potential for US-China trade tensions to persist or perhaps morph into more of a technology war (not my base case but clearly a possibility) and the Fed’s unwillingness to quash consensus expectations for at least one 2H19 rate cut, I think the likelihood of a Fed cut this year is inching closer to 50%.


Question number nine on the original “20 Questions” list was, “Will global and US earnings multiples continue to contract in 2019?” I gave this a 25% Probability. My original rationale can be read here.

To date my outlook remains steady, even with the May downdraft. The multiple expansion I anticipated certainly occurred more rapidly than I expected, with global multiples on 2019 estimated EPS now back above 14x and the US multiple back to 16x. The absence of any sustained uptick in inflation—something I have discussed at length in previous market overviews—has enabled the Fed to pivot away from rate hikes and allowed interest rates to remain in the price-to-earnings friendly range of 2.1%-2.6%. Again, there are clear risks on either side of that range. An inflation spike, exacerbated by rising wages and tariffs can’t be ruled out completely. On the other side, global growth trends remain tenuous and weakness from China, Europe/Brexit, and elsewhere could reignite the deflationary fears that have lingered from the darkest days of the 2008-2009 period.

We’ve said it before and we’ll say it again—one cannot argue that the global economy has normalized from the 2008 financial crisis with upwards of $11 trillion in negative yielding debt around the world. Still, as above, I think the balance of the existing data points to a Goldilocks-like outcome in 2019. Whether that view turns out to be merely a fairy tale will likely be the key capital market driver for the balance of the year.

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