Nov 26 2015

We will not yield

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One year after oil prices plummeted and the dollar strengthened, US corporate earnings are still struggling.

However, while the current reporting season is expected to show yet another decline in earnings a share, there is light at the end of the tunnel. Profit margins should slowly recover as companies cut costs and manage currency effects better. There is potential for revenues to surprise on the upside in 2016 if oil prices rise or if the dollar stops rising. Additionally, many underlying growth trends still look positive.

The roughly 17 per cent drop in EPS is much worse than initial analyst estimates. Revenue and profit margins both contributed to the weakness, with revenues 5.8 per cent lower as only 35 per cent of companies beat the top line compared to the historical average of 50 per cent, while operating margins declined from 10.1 per cent to 8.9 per cent.

We estimate that a good portion of the full-year EPS decline is directly attributable to the energy sector, with the remainder explained by weakness in other commodities and the broad dollar effect. Even excluding the energy and materials sectors, EPS is only expected to have grown by 2 per cent, held back by the stronger dollar. The dollar appreciated nearly 18 per cent in the third quarter of 2015, compared to a year earlier. Since nearly half of S&P 500 revenues are generated outside the US, this has had a dampening effect on overall revenue growth.

As the effects of weak oil prices and the stronger dollar roll off, earnings growth is expected to rebound in 2016, which will be positive for US equities. However, the maturing business cycle is resulting in slower growth, while full-year 2016 expectations are likely to be too high and will therefore have to come down over the course of the next several quarters. As the equity story becomes more nuanced and expectations are tempered, identifying good value opportunities will be increasingly important.

Current analyst estimates are expecting full-year 2016 EPS to grow by almost 20 per cent. If achieved, this would be the fastest full-year growth rate since the start of the recovery. However, such strong growth is unlikely unless there are significant boosts from international growth, oil prices and the dollar. Three factors are likely to constrain expansion.

First, profit margins, which are near historical highs, should face downward pressure. Labour costs, which have remained dormant, should begin to accelerate as the US approaches full employment. Many companies, which have cut costs, may find it worthwhile to now spend a bit as sentiment improves and the economy continues to chug along. This will reduce margins, which have been the largest contributor to the high levels of corporate profitability seen over the past seven years.

A rebound in commodity sectors will counterbalance this somewhat. Margins in the energy and materials sector should slowly recover over the next year even if commodity prices remain depressed, supported by consolidation and aggressive cost-cutting. And if oil prices rise gradually, the energy sector could even contribute positively to EPS by the fourth quarter of 2016.

Second, S&P 500 revenue growth has averaged only 3.5 per cent over this expansion. Without further margin expansion, revenue growth would have to accelerate dramatically to make up the difference. This cycle has only experienced two quarters of double-digit revenue growth, both dating back to the first half of 2011. With US nominal GDP growth modest, and international growth in the doldrums, it is highly unlikely that revenue growth will provide a sufficient boost to earnings growth.

Finally, share buybacks have likely reached peak levels, especially as corporate confidence improves and companies find other uses for cash, such as reinvestment and acquisitions.

Using reasonable assumptions on revenue growth, margin expansion and share buybacks, it could be possible to achieve 7 per cent to 10 per cent EPS growth over the next year. While lower than current expectations, this would still support US equity returns after a slow 2015. The risks are clear: global growth stagnates more than expected, the US business cycle reaches its end, or companies are simply unable to adjust to macro-economic headwinds. Nevertheless, we believe that US growth will continue, albeit at a slower pace, and this should support continued revenue growth, a recovery in margins and multiple expansion.

Nandini Ramakrishnan is global market strategist at JP Morgan Asset Management