U.S. corporate earnings growth looks poised to slow from a blistering pace, posing a potential new challenge to a long bull market that is already contending with slower global-growth momentum and rising interest rates.
Earnings growth has accelerated in recent quarters, helping drive major U.S. stock indexes to new highs and keeping share valuations from getting too stretched as prices rose. That expansion reached a new high in the first quarter, when U.S. corporations grew their earnings at 25%, the fastest pace since the second half of 2010, according to FactSet.
Now, many analysts say the first quarter could represent a peak in profit growth. Earnings growth is expected at 19% in the second quarter, 21% in the third and 17% in the fourth, according to FactSet. Earnings are expected to grow only in the single- to low-double-digit range next year.
A peak in earnings growth doesn’t always signal that rallies are about to fizzle, and analysts recognize that earnings growth would inevitably slow following a one-time boost from the federal tax overhaul. Moreover, not all analysts are convinced that profit growth has to slide. With the U.S. economy showing renewed signs of strength and consumer and small-business confidence riding high, some analysts say earnings growth can remain near the current lofty levels.
But a steep drop off in earnings growth in the months ahead would come at an inopportune time. After a nine-year bull run, stock prices reflect a rosy outlook that is already showing signs of fading on a number of fronts. The global growth momentum that powered stocks higher at the end of last year is slowing in Europe and other major economies. The Federal Reserve indicated on Wednesday it expects to raise interest rates at least four times this year, and the threat of a trade war looms after the U.S. and China announced new tariffs against each other on Friday.
Those and other concerns have deflated the stock market after a big year in 2017. The S&P 500 has risen just 4% this year and has been essentially flat since January. The index has gone 97 trading days since its last all-time high—the longest record drought since the period from May 2015 to July 2016, according to the WSJ Market Data Group. On Friday, the S&P 500 fell 0.1%, while the Dow Jones Industrial Average lost 0.3% and posted its biggest one-week decline since March.
“We’re at an interesting inflection point where we’re moving later into the cycle,” said Mark Haefele, chief investment officer at UBS Global Wealth Management. “Whether earnings roll over is going to be the deciding factor that ends this cycle.”
An analysis by RBC Capital Markets suggests stock returns have historically suffered when earnings stopped growing altogether and began contracting. In 1999, the year-over-year earnings growth rate for S&P 500 companies peaked in the third quarter of that year at 22%.
Corporate earnings then began contracting the next year as a slew of dot-com startups ranging from eToys to health information site drkoop.com reported ballooning losses, layoffs and closures. That sent the S&P 500 down 36% in the three years after the peak in earnings growth.
A similar pattern happened after the pace of earnings growth jumped in 2006, only to tumble the following year as the U.S. entered a recession. The S&P 500 would go onto lose 21% in the three years after earnings growth peaked.
Yet in cases when the companies continued to grow earnings, albeit at a slower pace—something RBC says happened after 1993, 2004 and 2009—the stock market continued to churn out double-digit percentage gains over the following three years.
Some investors think that could be the case this time. Recent data show the U.S. economy is still on solid footing, which they say suggests that companies are unlikely to post a sudden drop-off in earnings for now.
“It’s unsustainable to expect you’re going to get 26% earnings growth every year,” said Scot Lance, managing director at Titus Wealth Management in Larkspur, Calif.
Without last year’s tax cuts, companies would have grown first-quarter earnings at a single-digit pace, Mr. Lance said. That rate should still support further stock gains, he said, because companies have also been growing their revenues, a sign that recent gains haven’t just come from cost-cutting.
What’s more, the prospect of peak U.S. earnings may not lead investors to look abroad. In its June fund manager survey, Bank of America Merrill Lynch found nearly two-thirds of investors ranked the U.S. as having the most favorable outlook in the world for corporate profits, the highest share to say so in 17 years.
Still, even those who remain relatively optimistic about the U.S. economy caution that decelerating earnings growth could start to take its toll on the market.
For years, ultralow interest rates around the world have made relatively risky stocks attractive to investors searching for yield. As inflation ticks higher, pushing the Federal Reserve to further tighten monetary policy, “the discount rate changes and people are going to want more earnings,” said UBS’s Mr. Haefele.
Stocks look less expensive than they did at the start of the year, in part because the market remains below its January high. The S&P 500 trades at 16.6 times expected earnings over the next 12 months, above its 10-year average but down from 18.6 late January, according to the WSJ Market Data Group.
As earnings growth slows down, that calculus will shift and stocks will look more pricey. That is something investors say could make it more difficult for the stock market to keep rallying.
“The market isn’t going to overpay for these earnings,” said Katie Nixon, chief investment officer at Northern Trust Wealth Management. - WSJ
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