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February 28, 2019

Is An Earnings Recession On The Way?

As the fourth quarter earnings season wraps up, it marks the fifth consecutive quarter of double-digit earnings growth for Standard & Poor's (S&P 500) companies. When finally tallied, 2018 earnings are expected to grow over 20%. The Trump Administration’s tax breaks were a significant catalyst, as were record stock buybacks.

Companies are cautious, and there is a chorus of equity analysts suggesting that earnings growth could easily tip into recession this year. FactSet, an analytics service that aggregates equity analyst’s views, expects first quarter earnings to be down 2.5% from levels a year ago. Analysts also expect a sluggish second quarter, but see an improving second half, resulting in a 4.5% earnings increase for the full year. This is not disastrous, but it is still fairly tame.

S&P 500 – Earnings Growth Outlook Q1 2019

Source: FactSet, February 22, 2019

S&P 500 Earnings Growth Outlook Q1 2019 Sun Life using data from Factset

So, where do we go from here? Equity analysts are sullen, but the potential for upside surprises is being ignored. Given the market outlook, we still expect equities to deliver solid returns in 2019.

Trade Talks And Oil Price Jitters Abate

Sectors with significant exposure to trade, such as Information Technology, Consumer Discretionary, Consumer Staples and Communication Services, are expected to take a hit. First quarter earnings for Information Technology in particular, which generates almost 60% of its revenue overseas and has turbocharged equity markets over the last several years, is forecast to be down 10%.

S&P 500 – Earnings Growth Outlook Full Year 2019

Source: FactSet, February 22, 2019

S&P 500 Earnings Growth Outlook Full Year 2019 Sun Life using data from Factset

The good news is that President Trump has extended the March 1 deadline for additional trade tariffs on $200 billion of Chinese goods, a sign that a deal could potentially be reached. The U.S. realizes it cannot recklessly disrupt China’s growth and expect to escape retaliation or knock on effects. And both leaders are motivated to post some wins: President Trump as he gears up for re-election, and President Xi Jinping as he hosts the 100th year anniversary celebration of the Communist Party in 2021. Both need a strong economy to help underscore their claims of reliable stewardship.

Meanwhile, negative oil sentiment is dragging down the Energy sector. However, Saudi Arabia and Russia continue to cooperate and cut supply to rebalance the market after the U.S. unexpectedly pulled back from sanctioning Iranian oil exports. Saudi Arabia remains disciplined in its supply management and is cutting more than planned. Its fiscal budget requires Brent oil prices of over $80 per barrel, which means it is intent on pushing prices up – and given demand expectations later in the year, those price goals looks credible.

Investors Pleasantly Surprised By Fed

Toward the end of last year, markets corrected as they feared the Federal Reserve Bank of the United States (Fed)’ rate hikes would stall growth. Fed Chair Jerome Powell is now signaling “patience,” indicating to investors that the Fed is close to ending its tightening cycle, which will eliminate considerable uncertainty and allow markets to focus on company fundamentals.

And even though there may be near-term blips in the profit picture, U.S. companies are generally in solid shape.

Some of that was evident in the market’s reaction to fourth quarter earnings. Over the last five years, if companies had positive earnings surprises their stock jumped 1.0% over the following two days, while those that disappointed were down 2.6%.

In contrast, this quarter saw a warmer embrace as companies with earnings surprises were up 2.1% and those that missed expectations were down only 0.7%. This confirms that investors were bracing for worse news and were relieved that conditions were more robust than initially feared.

Another 2016?

Remember, we’ve been here before. The last earnings recession started towards the end of 2014.

Oil prices, which had hit a high in the summer of 2014, were cut in half by year-end as Saudi Arabia refused to curb supply and make room for U.S. shale production. That standoff continued in 2015 driving oil to a low by early 2016 as Saudi eventually conceded to supply cuts and prices started to recover.

While this oversupply played out, S&P 500 earnings dipped and didn’t turn positive until the end of 2016. However, the stock market started to recover at the beginning of 2016 as it recognized global growth was back on track and hit a new high that summer.

S&P 500 Index Earnings Recession 2015-16

Source: Bloomberg

S&P 500 Index Earning Recession 2015 - 16 Sun Life

Some of this same pattern seems to be playing out today. Markets initially worried that the Fed would derail growth are now confident it will tread softly. Investors are starting to look beyond the near term earnings noise and recognize that fundamental drivers are still strong.

This material contains opinions of the author, but not necessarily those of Sun Life or its subsidiaries and/or affiliates.