Consensus on economic growth too negative

A decelerating US economy and high profit margins are making it steadily more difficult for US corporations to increase earnings.

Companies in the S&P 500 managed to surpass analyst estimates this quarter at nearly the same rate as last quarter (4.6 per cent for the second quarter of 2012 compared to 6.1 per cent previously), but earnings growth was so low that it added little to the final total. With most of the index having reported for the second quarter, earnings rose just 1.3 per cent compared to 9 per cent during the first three months of the year.

Results are not actually as bad as they first appear, however, as they are distorted by the swings in commodity prices over the last year. For example, oil prices rose 12 per cent from the first quarter of 2011 to 2012, while they fell by 7 per cent in the subsequent quarter. Stripping out the energy and materials sectors increases the growth rate to 6.1 per cent, but that is still half the rate achieved by the same companies in the first quarter of 2012.

Next quarter is unlikely to be much better. Analyst revisions for the index have been negative for the last several weeks and forecasts now are for a contraction of 1.4 per cent. The energy and materials sectors again explain some of this decline and excluding them boosts the gain to 3.2 per cent, but it is still a deceleration from the second quarter. Only in the fourth quarter does the growth rate return to more normal levels at nearly 12 per cent, but this is likely to fall as estimates are adjusted to account for the drag on the US economy from the ongoing problems in Europe.

In spite of the lack of momentum in earnings, the S&P 500 has still managed gains of well over 10 per cent so far this year. Much of this has simply been a rebound from the sell-off last autumn. The index has only recently surpassed the levels of July 2011 (for the second time as the rally in March earlier this year was not sustained).

The crisis in Europe continues to drag on and remains the principal threat to the market, but valuations are still well below average. Two sectors are notable exceptions, however. Telecom services, the best performing sector this year with a gain of over 20 per cent, is trading at a hefty premium to its average forward multiple since 1995. The utilities sector appears nearly as rich, though returns have lagged the broader index.

We anticipate a gradual reduction in negative sentiment about the cohesion of the eurozone, though there will continue to be bouts of anxiety around Greece or implementation of the European Stability Mechanism (ESM).

While US economic growth has slowed this summer, we expect a pickup over the rest of the year. The recent retail sales figures suggest that consumers are opening up their wallets again and credit growth should accelerate.