John Lynch Chief Investment Strategist, LPL Financial
Earnings season off to a good start. Third quarter earnings season is rolling and, so far, results have been quite good overall, supported by strong U.S. economic growth, robust U.S. manufacturing activity, tax cuts, and big increases in energy and financials sector profits. Below we recap the results of earnings season thus far, discuss why we expect strong results to continue throughout the reporting season, and highlight several keys we are watching.
GOOD NUMBERS SO FAR
We’re not even 20% through third quarter earnings results, but the numbers have been solid thus far despite pressure on profit margins from tariffs and higher wages. With 84 S&P 500 companies having reported, year-over-year earnings growth for the index is tracking to 22%, slightly above the 21.6% figure at quarter end and 3 percentage points lower than the second quarter [Figure 1]. Revenue growth is tracking to a solid 7.3% increase, below last quarter’s 9.5% increase. A solid and above-average 79% of companies have beaten earnings estimates, while the share of companies that have beaten revenue targets—62%—is above the long-term average of 60%, but below the 73% average of the past four quarters. The modest upside to estimates and drop in the revenue beat rate indicate a smaller upside surprise to the current 22% pace is likely—but a potential 23–24% earnings growth rate is hardly something to sneeze at.
Looking ahead, despite the aforementioned margin headwinds and slowing growth in key overseas economies, notably Europe and China, estimates for the current fourth quarter (calling for growth of over 20%) and 2019 (an increase of more than 10%) have barely budged in October. Resilient estimates are encouraging amid several company anecdotes about tariff impacts and slower growth overseas.
POSITIVE MACRO SIGNALS
We think the good results will continue this earnings season for a number of reasons. Most obvious is the favorable macroeconomic environment. In the U.S., economic growth has picked up and manufacturing activity is humming. Along those lines, two of our favorite earnings relationships are shown in Figures 2 and 3.
Figure 2 shows the relationship between nominal GDP growth (real GDP growth plus inflation) and S&P 500 revenue. You see that as economic growth accelerates, revenue growth tends to improve as well. We certainly saw this relationship hold in the second quarter of 2018 when nominal GDP growth rose at its fastest level of the economic expansion: 5.4% on a year-over-year basis and 7.6% quarter over quarter annualized. We believe the outlook for corporate profits over the next several quarters is positive, supported by upward trajectories in economic growth—bolstered by fiscal stimulus— and inflation.
A healthy manufacturing sector also bodes well for the earnings outlook, as shown in Figure 3. Because of S&P 500 companies’ emphasis on manufacturing, the Institute for Supply Management (ISM) Purchasing Managers’ Index for Manufacturing has historically correlated well with year-over-year S&P 500 earnings growth, with about six months of lead time. With the index level at roughly 60 and near expansion highs, we believe the strong earnings momentum from the second quarter will continue through year-end and probably beyond (even though the anniversary of the December 2017 tax cuts will cause earnings growth to slow in the first quarter of 2019).