Econosights - The outlook for US corporates and the US economy

Introduction

The end of the September quarter US earnings season is a good opportunity to assess the health of US corporates. In this Econosights we review the key take-outs from US reporting season and its implications for the broader US economy.

The outlook for US earnings

US public companies report their earnings in the weeks after the end of each quarter (with results released from mid-January, April, July and October) with these periods known as “reporting season”. European earnings are reported at a similar time while in Australia earnings announcements are done twice a year in February and August (but it can vary depending on the business). US earnings tend to be watched closely because of the implications for US sharemarkets and the flow through to other global markets.

One method we use to analyse reporting season is to track actual earnings compared to market expectations. In the September quarter, close to 80% of company results beat expectations (see chart below).

This is a good outcome considering that in reporting season over the past 10 years 75% of companies have beat market expectations.

Tracking changes in earnings-per-share growth is also useful. President Trump’s corporate tax cuts supercharged corporate profits in 2018, which rose by just over 20% year on year. This was followed by expectations of another year of strong profit growth between 10-15% in 2019. These expectations have since disappointed and earnings growth in 2019 is likely to be closer to 2-4% year on year. This would be the weakest rate of corporate earnings growth since 2016 (see chart below) when earnings took a hit from the collapse in the oil price.

While profit growth has weakened, earnings are unlikely to fall much further from here. Analysts expect earnings growth around 10% in 2020. Given the recent downgrades to profits and the numerous US growth risks, these estimates are probably too optimistic and on our estimates earnings will be closer to 5-10% in 2020. There could be some upside from a weaker $US. The $US has been depreciating over recent months and is likely to remain below its 2019 highs as global growth improves (which usually pushes the $US down as other major currencies lift). A lower currency is positive for earnings with 40% of US sales derived from offshore spending which benefits from a lower currency. On the flipside, US tech stocks (which form a large 20% weight of the US S&P sharemarket index) may come under pressure given recent run-ups have caused over-valuation concerns and the risks around tightening regulation (especially if the Democrats win the 2020 US Presidential election).

Expectations for corporate earnings growth globally are still holding up and average around 7% for 2020 (see next chart) with estimates still the highest for the US.

What about the outlook for business investment?

The outlook for business investment is also an indicator of corporate health and business sentiment. Tax breaks in 2018 were hoped to improve investment incentives for US firms. There were some signs of non-residential construction rising in early 2018 but this quickly faded as the trade war between the US and China (and less so between the US and Europe/Mexico/Canada) ramped up. Non-residential construction activity has now fallen for the past two quarters. The trade war creates unnecessary uncertainty for businesses because of the disruption to production lines, supply chains and the increase in costs. In the US, large business confidence has taken a hit (see chart below).

The current trade standstill is a step in the right direction but doesn’t completely remove uncertainty for businesses. It’s difficult to see the trade dispute completely dissipating before the 2020 presidential election. Some tariffs are likely to be delayed or even rolled back but President Trump is still expected to maintain a tough stance on China.

The election also adds another level of uncertainty for investment with some research showing that business investment tends to be low in pre-election years. Business investment may benefit from an easing in lending standards (see chart below) which have become slightly easier recently (but are still tighter compared to pre-Global Financial Crisis standards).

We see business investment growth remaining low in 2020 as the trade war and presidential election looms over firms but investment is unlikely to be a drag on GDP growth.

Growth in residential construction has been stronger than business investment. The outlook for housing investment mkremains positive thanks to the fall in US mortgage rates and recent declines in home construction which have led to concerns of undersupply of homes, especially as housing formation is rising again.

Should we worry about corporate leverage?

US lending standards remain fairly neutral. But, there is still a lot of concern about high US corporate debt. Record low interest rates and quantitative easing have reduced the cost of borrowing which has naturally lifted debt (and also profits). Corporate debt to GDP is around a record high at 47% of GDP and has been steadily increasing over the past decade (see red line in chart below) which is often cited as a risk to the outlook. But, the corporate debt to asset ratio (purple line in chart below) tells a completely different story with the ratio of corporate debt to assets at 26% of GDP, around its historical lows and has been relatively unchanged over the past 5-10 years. The debt to GDP ratio has problems because debt is measured as a stock while GDP is a measured as a flow so its not a like-for-like comparison. The debt-to-asset measure avoids this problem and is our preferable corporate debt indicator.

At a time when profit growth remains reasonable and interest rates are low, corporate debt serviceability is not an impediment to growth.

Implications for investors

US corporate earnings growth has weakened over the past year but still remains positive and should improve in 2020. While trade uncertainty is weighing on capital expenditure, the labour market remains strong, wages growth is rising and interest rate cuts from the US Fed are supporting the economy. Global growth is bottoming out and we expect a slow recovery in manufacturing activity which will be positive for cyclical stocks. This environment is positive for US corporates and shares in return. We see global share markets tracking higher over the next 6-12 months. Bond yields are also likely to edge a little higher in this environment of improving cyclical growth.