A myriad of factors can influence corporate profits: oil prices, currencies, wages, cost cuts, productivity, taxes, interest rates and many more. They all matter, but pale into insignificance compared with nominal economic growth.
It’s not so much economic growth itself that matters, but what it reflects. Real GDP growth is a good proxy for how much stuff companies sell (volume growth) and inflation is a good proxy for the price increases they can achieve (selling price growth). Together they give us revenue growth.
Revenue growth is the most reliable driver of earnings growth. When you are selling more stuff and are able to charge higher prices for it, it is relatively easy to cope with any headwinds on the cost side like those that we are seeing emerging in this 'late-cycle' economy.
This may seem counterintuitive, but makes sense when you remember that the growth rate of volume and selling prices applies to all of a company’s revenues. Assuming costs are lower than revenues, typically substantially, the growth rate on individual cost components will only apply to a much smaller amount.
Not convinced yet? Another way to think about this is by splitting revenues into profits and costs and splitting costs into fixed and variable costs. Even if a company’s input costs rise at twice the rate of its selling prices, as in the example below, this company would still produce positive earnings growth. This is the often under-estimated power of operating leverage at work and is also why economic growth as a proxy for revenue growth is so powerful.
Of course, operating leverage works both ways. When revenue growth turns negative, as it typically does in a recession, the hit to earnings can be devastating and just as easily under-estimated as on the way up.
As a result, it’s not surprising that our economists’ forecasts for GDP growth are the most important drivers of our views on how earnings will develop. It's not just the level of growth, but also the change in growth that matters, just as in Tim's model for whole economy profits. And of course US large cap companies don’t just rely on US GDP growth, so it’s important to weight regional GDP forecasts by where companies generate their sales.
Taking our current forecasts for global growth suggests that underlying growth of US earnings will slow down to mid-single digits next year and grind to a halt towards the end of 2019. Should the US economy slowdown further in 2020, earnings growth could dip into slightly negative territory for a few quarters. This scenario for S&P 500 earnings growth is not materially different from the one Tim laid out for US whole economy profits.
This could warrant a moderate downward adjustment in market expectations at some stage in 2019 and another one if the additional 2020 slowdown materialises. A slowdown to mid-single digits next year seems largely expected. Even perennially optimistic bottom-up analysts are forecasting lower than normal 9% earnings growth. Taking the historic average degree of over-estimating into account takes us closer to a relatively realistic 5% figure. This figure matches the top-down estimates in many sell-side reports published over the past few weeks, and the recent de-rating is also consistent with a downgrade in earnings growth expectations. Finally, low single digit earnings growth is typical of what we've experienced during most of this bull run so far.
The market reaction would depend on whether that slowdown was interpreted as temporary, like the oil-related slowdown of 2015, or as the start of an earnings recession. As meaningful earnings recessions are almost always driven by economic recessions, the answer to that question takes us back to our economists. Though our assessment is that the US economy is moving into the latter stages of the economic cycle, our forecasts for global growth remain well within the range of what we have seen in the past decade, rather than a new recession.
So, for the time being, the earnings outlook still looks supportive for this bull market. However, we believe it will provide less fuel than in the last two years, with question marks increasing as we head into 2020. We believe a post-tax reform world will deliver a lower, single digit earnings growth trend in the US, which is more aligned with other regions and not uncommon in late cycle phases. That underlying trend comes with plenty of two-way risk from a host of drivers, but the key remains, always, the global growth cycle.