Last updated: 06:09 / Friday, 22 August 2014
Insight by Robeco

Strong U.S. Earnings Season Bodes Well for Stocks

Strong U.S. Earnings Season Bodes Well for Stocks
  • US firms see 10% profits growth in first 6 months
  • Future growth may be limited though by rate rises
  • Positive outlook for capital spending as predicted
  • Geopolitical risk remains an important swing factor

A strong first half for US company earnings bodes well for stocks over the rest of the year, as the country continues to set the tone for global growth, says Robeco strategist Peter van der Welle.

Investors may increasingly look to the US for equity market returns later this year as the European economy remains sluggish, the end of tapering potentially threatens momentum in emerging markets, and the jury is out over whether ‘Abenomics’ is still working in Japan.

Two in three of the S&P 500 members that have so far reported first-half earnings have announced profit figures that were higher than expected, and US earnings are now at an all-time high. Their 3-month forward earnings forecasts for the next 12 months are also positive.

Earnings growth has averaged 10% on an annualized basis, thanks to record profit margin levels of 9.4% and increased sales. Profit margins have been sustained at record levels, helped by declining capital market interest rates since the start of the year, and by subdued wage rises.

“Sales growth is increasing as real US GDP growth rises and that should keep profit growth close to 10% for all of this year,” says Van der Welle. “The main component has been sales growth and very high profit margins, and the fundamentals remain healthy.”

US earnings are streets ahead of other regions in the world

Source: Robeco.

However from this point forward the upside is more limited, as US rates eventually start to rise and amid increased concerns about rising geopolitical risk, Van der Welle says. Indeed, worldwide equity markets tanked in the first week of August as the Iraqi conflict reared its head again, leading to a resumption of US air strikes.

Much depends on how US growth translates into company profits. Over the past 20 years, a 3% rate of real growth would have generated earnings growth of around 14%, but that is no longer to be expected. This is due to the current economic environment specifics; record high profit margins are not likely to expand further with higher interest rates, and ultimately, gradual rising wage pressures will negatively impact margins as well.

End of easy money

And of these expected headwinds for US earnings, it is the end of easy money which poses the biggest challenge for companies, Van der Welle warns. “We’ve seen lower rates with Treasury rates of 2.4% since the start of the year, and this has contributed to sustained profit margins,” he says.

“Companies will have locked in current rate costs in their planning through hedging and so forth, but rate rises will eventually feed into debt costs moving forward. We still hold the view that Treasury rates will increase towards 3%”

Despite the recent stock market correction, Van der Welle thinks investors will soon go back to looking at improved corporate fundamentals. “Many investors are waiting on the sidelines to see how the current geopolitical picture plays out,” he says. “We had a 4% correction in the S&P 500 due to Iraq and Ukraine, but a technical correction had been long-awaited since the last correction in January. We still have some geopolitical risk, but eventually the market will look through it and focus on the more positive earnings picture.”

Capex rises as predicted

Van der Welle says the positive US corporate outlook bodes well for increasing capital expenditure as companies sit on billions of dollars of cash saved during the deleveraging period since the financial crisis.

“When you look at Q2 GDP figures we have seen on average a 5% rise in capex growth, which confirms our call from last March that it would rise,” he says. “The stronger than expected first-half sales figures also imply more capital expenditure (to keep up with demand), as there has traditionally been a good correlation between net sales growth surprises and capex.”

“But it’s too early to say that capex really is rebounding because we need to see a strong third and fourth quarter, so let’s not cheer too early.”