During the first two quarters of 2019, S&P 500 earnings growth slowed significantly, although it remained modestly positive on a year-over-year basis. However, in the third quarter of the year, earnings declined slightly compared to the quarter one year ago. While comparatively weak, the most recent results were less negative than the market feared, with earnings relative to expectations once again coming in ahead of estimates (+4.7 percent). The market has largely shrugged off this weakening trend in earnings growth and continued to move higher, with one -year forward P/E ratios currently over 17x. Uncertainty surrounding tariffs and global growth remain, but equity values reflect optimism that the tariff situation will ultimately be resolved and central banks will remain supportive of the global economy.
Exhibit 1: Our thoughts from a fixed income perspective: sector results relative to expectations
|Negative||Modest negative||Neutral/mixed||Modest positive||Positive|
|Consumer Cyclical||Basic Materials||Consumer Non-Cyclical||Construction/Real Estate|
|Communications||US Banks & Other Finance|
Source: Aegon AM US.
Focus on the consumer: During the third quarter earnings season, multiple companies discussed US-China trade negotiations impacting business sentiment. How the consumer is holding-up, particularly in the US, may help determine if the macro impact is broadening. From a high level, we found that the US remains strong and Europe is stable, while the UK is reporting some weakness, China remains relatively stable with pockets of weakness, and Hong Kong is experiencing some weakness related to regional tensions.
The most mentioned uncertainties among management teams included: Brexit, political environment, US-China trade negotiations, and Hong Kong tensions. Some teams indicated they are mindful of these uncertainties in the current global environment, but noted overall consumer spending remained relatively steadfast, with the US consumer quoted to be "healthy."
A number of CEOs referenced low unemployment, raising wages, access to credit, and tax cuts as supportive to strong US consumer spending. A large US bank commented, "One metric we watch as a leading indicator is the proportion of customers who are paying only the minimum payment on their cards and over the past year that metric has been stable to slightly improving."
Brexit uncertainty continues to negatively impact consumer confidence in the UK causing consumer spending to decelerate in the region. An international retail supplier commented, "Uncertainty related to Brexit continues to impact consumer confidence, resulting in a slight deceleration in our UK market." Using a more limited sample, the Chinese consumer appears to be relatively resilient with some weakness in travel and home purchases.
Initial thoughts on 2020: During their most recent earnings calls, a number of companies gave their initial thoughts on the year ahead and some have provided guidance for 2020. While a number of companies acknowledge a slowing economy, though still positive, and the myriad of potential headwinds (tariffs, China, inventory destocking), expectations are generally for continued growth through 2020. Further, in order to offset slowing macro growth, management teams are focusing on internal initiatives to reduce costs and drive higher free cash flow.
Given recent weakness in industrial indicators, the industrial sector commentary suggests that the rates of decline are manageable, with most companies planning for stabilization in 2020. In general, backlogs are solid and companies are able to realize price increases. Even in sub-sectors like construction machinery, where weaker retail demand is expected to persist into 2020, overall equipment demand remains solid as customers have chosen to rent over buying in the near-term. Further, reduced retail inventories are expected to provide sales growth opportunities in the second half of next year. In addition, the indication is that 2020 may see earnings growth due to the benefit of cost reductions and lower commodity costs year-over-year.
Lodging and airline companies have indicated that 2020 should continue to see solid business from both corporate and leisure travel. While hotel RevPAR (revenue per available room) growth estimates for 2020 are modest, unit growth should continue to be solid. Hotel chains are seeing an uptick in the pace of group bookings for 2020 and indications for the convention business are also strong for next year. One international lodging company commented, "Booking pace for comparable hotels for 2020 is up at a mid-single digit rate year-over-year. About two-thirds of the group business expected for the year is already booked." Further, airlines are seeing healthy demand and, with increases to both prices and capacity, the industry expects to carry earnings momentum into 2020 as well.
One of the weakest sectors over the last couple of years has been energy. However, exploration and production (E&P) management commentary about 2020 indicates a more conservative approach to capital expenditures, with particular focus on free cash flow. Despite this reduction in capex, management teams are still pointing toward mid-single digit growth in oil production. Similarly, the midstream sector is also forecasting steep reductions in capital expenditures, but will likely benefit as existing projects come on line. While oilfield service companies appear to be most negatively impacted in the US by 2020 capex budgets, international growth should partially offset these headwinds. An oil field services firm remarked, "One more trend we are watching is the deceleration of incremental US production growth brought about by capital discipline. The record-breaking 2018 growth will not be replicated in 2019. In fact, current projections for 2020 indicate a further decline in production from the current year estimates."
Increasing Impact of ESG: Environmental, Social and Governance (ESG) issues continue to gain traction, with commentary addressing such topics increasing across a diverse set of sectors. Several companies highlighted the potential to leverage ESG trends in order to enhance profit. Financial firms increasingly see the opportunity to grow ESG product lines, which appeal to a growing investor base, provide capital to ESG focused companies and, at the same time, drive profitability. Utilities continue to find opportunities for improving their environmental impact through accelerated investment in renewable energy projects, which also support ongoing growth and profitability targets. One such utility commented, "We continue to execute well on our major initiatives, including continuing to capitalize on one of the best renewable development periods in our history." Auto companies are intensifying their effort in the development and production of electric vehicles in order to enhance product lines, drive profits and stay relevant over the long-term.
ESG trends are also having interesting impacts on capital markets. Evidence of growing demand for green bonds is seen in rising issuance, an expanding investor base and declining borrowing costs. In addition, the energy sector continues to improve its ESG disclosure, providing greater transparency to the investment community regarding its longer-term fit in the transition to a carbon-free environment, which should help these companies maintain ongoing access to the capital markets and fund their ongoing investment needs at acceptable levels.
Whatever the motivations may be, ESG topics have emerged as key issues and innovative companies are using this trend to develop new business opportunities, improve profitability and maintain relevance in a changing world. Customers and investors alike are demanding more attention be paid to ESG issues and corporate America has taken note.
Global headwinds remained the focus for companies this quarter and one of the main variables that management teams are anticipating will continue to affect growth. As we enter 2020, many firms anticipate growth, albeit at a slower rate. The consumer remains resilient in the US, however, some areas of the world continue to have challenges to overcome. Separately, ESG continues to gain traction and is being increasingly integrated into business plans.
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