S&P 500 earnings are on track to contract for a second straight quarter, driving headlines to bemoan the implications of an “earnings recession.” Many seem convinced the US-China “trade war” is finally weighing on corporate profits, and some think more trouble looms as analysts now forecast falling Q3 earnings. But as fears swirl about tariffs and slowing earnings growth, a little digging shows Q2 numbers aren’t as bad as most seem to think—Corporate America is doing alright, in our view.
Per FactSet, with 493 S&P 500 companies reporting as of 8/28/2019, Q2 earnings are expected to contract -0.4% y/y, a tad worse than Q1’s -0.3%. Of the S&P 500’s 11 sectors, 5 expanded and 6 contracted. Materials, Industrials and Information Technology were the three biggest detractors, with weakness concentrated in a few areas. For Tech, the Semiconductor & Semiconductor Equipment and Technology Hardware Storage & Peripherals categories were the only detractors. In addition to some weaker-than-expected demand, uncertainty from export restrictions on a major Chinese telecom company impacted shipments. Industrials’ struggles were tied to a big aerospace manufacturer’s ongoing issues with one of its planes, while one mining company accounted for the lion’s share of Materials’ weakness. Though Q2’s numbers weren’t robust even outside these weak spots, focusing on earnings alone overlooks a positive: sales, which are still growing at a nice clip. Q2 revenues rose 4.0% y/y, adding to their steady positive streak. Considering sales growth, rather than cost cuts, tends to drive earnings later in the business cycle, still-rising revenues indicate business is healthy in Corporate America.
Interestingly, many analysts glommed on to the uptick in companies mentioning tariffs during their Q2 earnings calls. One FactSet analysis noted a 40% q/q rise in tariff mentions—with Industrials leading all sectors. Yet mentions alone don’t tell you how firms viewed tariffs—good, bad or neutral. So your intrepid MarketMinder Editorial Staff combed through the 140-plus earnings call transcripts containing the word “tariff” to see how company executives were feeling about these widely hyped levies. The verdict? While most firms acknowledged the headwind—a material one for a handful—the vast majority said they were able to mitigate tariffs’ impact. In many executives’ view, their teams were well-prepared and performed admirably to defang tariffs—which they largely said weren’t too onerous to begin with.
Here is a sampling, courtesy of earnings calls transcripts from FactSet:
“We continued to effectively manage the impact of tariffs through well-executed mitigation efforts and are in the final stages of eliminating all spin-related stranded costs before year-end.” – Greg Lewis, Senior Vice President & Chief Financial Officer, Honeywell International, Inc.
“Total inflation, the impact of tariffs was a bit less than 1.5%. So we had a positive spread and we're very pleased with the results. … [later in the call] So our sourcing teams are doing an outstanding job, absolutely outstanding job of dealing with the mitigation of tariffs and moving us to different regions of the world and delivering incremental savings.” – David A. Zapico, Chairman and Chief Executive Officer, AMETEK, Inc.
“Price realization has been outstanding across our businesses and we're effectively managing all inflation and tariff-related costs with an 80-basis-point spread in the second quarter.” – Michael W. Lamach, Chairman and Chief Executive Officer, Ingersoll-Rand, Plc.
“In terms of the tariff that Microchip pays, the effect of this additional $300 million is virtually nothing. There could be [a] small amount of our development tools or something. We're talking thousands of dollars, not millions of dollars. So, that is not the effect.” – Steve Sanghi, Chairman & Chief Executive Officer, Microchip Technology, Inc.
“…we do not feel, even if the tariffs were to go to the full 25% that, that would be – impact our earnings. We believe we have enough opportunity to mitigate some of those issues, as you saw we just did with the increase of the 10% on those categories. So, we're comfortable that both in this year and as we move forward that will not impact our earnings projections.” – John D. Idol, Chairman, Chief Executive Officer & Director, Capri Holdings Ltd.
Now, we wouldn’t treat these comments as the gospel. Earnings calls are rich fodder for marketing spin as executives can trumpet how they are succeeding despite external headwinds—or how their struggles stem from them. Still, CEOs’ comments are further evidence of a theme we have discussed before: Tariffs don’t pack the wallop many fear because companies can mitigate them.
But with the dour mood still prevalent, analysts have extrapolated Q2 weakness to Q3. Right now, Q3 earnings are expected to fall -3.5% y/y, extending the “earnings recession. Yet we caution against taking these forecasts as ironclad prophecy. Consider: At the start of the year, analysts expected Q1 earnings to grow 2.9% y/y.[ii] But by Q1’s end, those expectations dropped to -3.4% y/y.[iii] Similarly, analysts were pessimistic about Q2 earnings, projecting -2.3% y/y at the start of the season.[iv] Yet reality beat those dour expectations. Q1 earnings ended up contracting just -0.3% y/y. As it stands now, Q2 earnings contracted -0.4% y/y. Maybe Q3 earnings fall, maybe they don’t—either way, it needn’t spell the bull market’s end.
Moreover, though earnings growth has slowed, this is neither a surprise nor unusual. Some of it is a function of math—i.e., the one-time boost from 2017’s corporate tax reform falling out of the comparison—but fluctuating and slowing earnings aren’t unheard of, especially in a mature economic expansion. Neither are “earnings recessions.” We had one from 2015 – 2016. That didn’t derail the bull market or US economy. Back in the late 1990s, earnings dipped for a stretch. That wasn’t a signal to dump stocks. For investors, keep in mind: Stocks don’t need gangbusters earnings growth to rise. What matters more: whether investors’ expectations for earnings over the next 12-18 months or so are too timid or too lofty. In a still-growing global economy, companies are still profitable. That so few seem to appreciate this is bullish.
[i] Source: FactSet Earnings Scorecard for Q3 2019, as of 8/29/2019.
[ii] Source: FactSet Earnings Insight for the week ending 1/4/2019.
[iii] Source: FactSet Earnings Insight for the week ending 3/8/2019.
[iv] Source: FactSet Earnings Insight for the week ending 6/7/2019.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.