The recently completed US equity earnings season gives reasons for investors to feel particularly bullish. It was, in a word, impressive, with 77 per cent of companies beating earnings per share estimates. This robust rate of earnings growth is largely due to weak earnings in the first quarter of 2016, and these base effects should gradually decline over the remainder of the year.
However, it is also a function of moderate nominal growth and healthy profit margins, as wage growth has been muted and interest rates remain low and stable.
While in aggregate earnings growth looks solid, beneath the surface, some sectors look better than others. Financials, technology, materials and healthcare all seem to have enjoyed solid earnings growth in the first quarter. Financials were supported by better capital markets revenue and declining credit provisions due to stronger energy company balance sheets. Additionally, higher interest rates helped boost profitability at the banks, and with expenses relatively unchanged last quarter, operating margins enjoyed some moderate expansion.
Technology and materials both benefited from a weaker US dollar, as the broad trade-weighted dollar index fell by nearly 2 per cent in the first quarter. The technology sector sources more revenue from abroad. Materials and technology are not the only sectors that benefited from a weaker US dollar. The industrial sector, which looked set to see earnings contract again in the first quarter of 2017, has posted modest earnings growth with an average earnings surprise of nearly 9 per cent. Although energy companies continue to delay new projects, defence budgets have yet to be increased and airlines are under pressure due to higher fuel prices, strength in the global manufacturing purchasing managers index (PMI) and less drag from inventories are being reflected in first-quarter profits.
Within healthcare, all the rumbling about reform and the Affordable Care Act did not impact first-quarter earnings. Rather, there are other forces at work – large insurers began to reduce their participation in public exchanges this year, lowering expenses, and 2016 saw the fewest drugs receive Food and Drug Administration Approval (FDA) since 2010. This has benefited pharmaceutical and biotech companies in particular, as the drug landscape has become less competitive.
Things in the energy sector improved in the first quarter, but these companies are not out of the woods yet. The average price of West Texas Intermediate (WTI) oil in the first quarter of 2017 was 5.2 per cent higher than in the fourth quarter of 2016, and nearly 55 per cent higher than in the first quarter of last year, but earnings estimates for the first quarter suggest profitability remains far short of levels achieved when oil traded at $100 a barrel.
While this points to some disappointment, it is important to remember that one of the biggest detractors from energy sector profits over the past few years has been write-downs. An outsized share of these impairment charges tend to be taken in the fourth quarter of the calendar year; the beginning of a new year, coupled with an improvement in operating efficiency, suggests some of the previous pressure on energy profits may have been alleviated in the first quarter. However, the longer-term risk to energy profits lies in the balance between supply and demand.
Oil prices currently support continued pumping in the US, but not necessarily new drilling. This dynamic should support a gradual reduction in excess supply, allowing energy sector profitability to improve. However, if oil companies start pumping too aggressively, supply will once again begin to outstrip demand, pushing oil prices lower and dragging on profitability.
With the headwinds of lower energy prices and a stronger dollar seemingly behind us, earnings growth should be able to continue at a moderate pace. Current year-over-year growth rates are unsustainable, but a backdrop of better nominal economic growth, stable interest rates and subdued wage growth should support healthy operating margins and lead to earnings growth in the mid to high single digits.
Nandini Ramakrishnan is global market strategist of JP Morgan Asset Management
