Earnings tend to be a good indicator of employment, which drives income and consumer spending and becomes a virtuous cycle.- John Lynch - LPL Chief Investment Strategist
The third quarter earnings season is underway, and the signs are pointing to continued economic growth and steady earnings gains into 2019. In this week’s podcasts, LPL Financial’s research strategists discuss the positive factors that are outweighing any potentially damaging economic hits due to tariffs and other issues.
The initial read on third quarter GDP will be reported on Friday, October 26, and consensus forecasts (Federal Reserve Bank of Philadelphia and Haver Analytics) are calling for an annualized increase in the low three percent range. With solid consumer spending trends and support from the past year’s fiscal stimulus, a favorable third quarter economic growth trajectory should continue through the end of the year and into the next.
As the LPL research strategists note, a good economy has positive implications for corporate profits and stress that, over time, can be the biggest driver behind stock prices.
Tune into the full LPL Financial Market Signals podcast to learn more about why LPL’s research strategists see the U.S. economy picking up speed.
GDP growth including inflation, or nominal GDP, has historically correlated well to corporate revenue. With the U.S. economy growing solidly and accelerating, we believe the intermediate term earnings outlook is bright.
Healthy consumer spending should provide solid base for GDP growth in the third quarter. Trade tensions and extreme weather may cause distortions in the data.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in this material may not develop as predicted.
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John Lynch: So for today's agenda Jeff, I think it's important, this week’s big news will be third quarter GDP report. With the midterm elections coming up, I think it'll be very important for us to provide our listeners with some of our thoughts on some of the policy implications for the economy and the financial markets.
John Lynch: And finally it always comes down to the Holy Grail, which you and I believe are earnings. We've got, so far, pretty good earnings for the third quarter. So we'll cover GDP policy and earnings for this call today.
John Lynch: First off on GDP, Jeff, we clearly had very strong growth in the second quarter. We were north of 4% US GDP, Gross Domestic Product, total output of all goods and services in the US economy. A lot of that was fueled by improvements relative to consumption, relative to capital investment.
John Lynch: Clearly, some of the changes we've seen in fiscal policy, as we wrote in the 2018 Outlook, really came to fruition in the second quarter, whether it be reduced regulation in financials and energy, the lower tax rate for consumers, and clearly the incentives for business investment and repatriation. That's really helped drive growth.
John Lynch: What are you looking at for the third quarter, Jeff?
Jeff Buchbinder: On GDP, we're looking at 3.2 consensus, and it could even be better than that. A little bit of an uptrend in terms of forecast. That GDP number was 3% just a couple months ago, now 3.2 for Bloomberg consensus. Then you've got the Atlanta Fed nowcast number that's 3.8. That can be a little high at times, but nonetheless, a lot of folks think that we could be in the mid-threes or even a little bit better this quarter, which would be really strong.
Jeff Buchbinder: The probably best news for me is the earnings guide here, is the connection between GDP and manufacturing and earnings. Good numbers across the board, I think, bode well for earning season, which I know we're gonna talk about more in a bit.
John Lynch: That's right. But you make a good point, because earnings tend to be a good indicator for employment, tend to be a good indicator therefore for income, tend to be a good indicator for consumption, and it just becomes a virtuous cycle. GDP, we're excited to see that number.
John Lynch: You mentioned the Atlanta Fed. Very interesting work they do, but it always seems to be higher than consensus, and I'm not sure we'll see a print of 3.8, although I'm not sure anybody will be happier about that than me. But nonetheless, we get a 3-handle mid-threes, particularly given the hurricane, right?
John Lynch: I think we need to be mindful of that, that we might lose half a percent of GDP this quarter compared to last quarter as a result of the two hurricanes that we experienced over the past four to six weeks. That could weigh on activity for the third quarter, but history has shown that whatever hit you take to output as a result of a disaster such as that, or such as those, the rebuild tends to be additive to GDP going forward. I think that's something investors should keep in mind.
John Lynch: Another hot topic with the election only a few weeks away for the midterms, policy continues to play a very big role, wouldn't you agree Jeff? Not only in the economy, but the financial markets?
Jeff Buchbinder: Oh absolutely. It's in the headlines today. Republicans are talking about a tax cut, potentially, before the midterms. I think it's important for folks to keep in mind that it's not like tax reform impacts just end at December 31st, '18, right?
Jeff Buchbinder: There's a lot of talk about how we're anniversary-ing those effects and that earnings will slow, or the economy will slow, frankly, in 2019. But there's some pieces to that. It's not just the cut in the tax rate, the corporate tax rate, there's other things there too, like capital spending incentives, and the repatriation.
Jeff Buchbinder: Those have tails to them, and we're seeing benefits of those now and we're gonna see benefits to those, I think, into '19.
John Lynch: I'd have to agree. We have some legs to this expansion, and policy has a lot to do with it. You made a comment about the ... We're taping this early Monday morning, and we did see headlines this morning regarding the potential for a tax cut before the midterms. Now that's only a couple weeks away and Congress is not in session, so I'm not gonna bet the farm on a tax cut before the midterm.
John Lynch: But I do think it's important for investors to keep in mind our belief that there is some momentum behind these fiscal incentives. I see an awful lot of commentary about how we're already seeing the cliff on this stuff. If consumers and small businesses saw a 120 billion this year and then businesses saw an additional 80 billion in incentives ... in lower tax rate, rather, we think the consumer alone will see 200 billion in 2019, particularly when you look at AMT refunds, which were not included, which were not part of, personal consumption this year.
John Lynch: When you factor that in, I use the 2003-2004 example relative to repatriation when there was 600 billion overseas. They had the tax holiday then, and half of that came back, so we were looking at two trillion in overseas profits. We suspect half of that will come back.
John Lynch: We saw, I guess, the first print in the first quarter was about 300 billion. The second print in the second quarter was 150, so that's 450 billion already, year-to-date.
John Lynch: We've got a couple of 100 billion in tax receipts. We have government spending. We had that additional spending package in February or March of this year that called for an additional 300 billion in spending over a two year period, so you're looking at 150 billion there.
John Lynch: Pretty soon we're talking real money to offset some of these tariff concerns. What do you have to say about that, Jeff?
Jeff Buchbinder: The numbers are really compelling when you think about, even if you have a ... the tariffs rates go up to 25% ... The amount of stimulus it's been put into this economy is enormous. Even if you want to make a very conservative estimate for repatriation dollars, you could easily come up with a number like 800 billion total, including the tax cuts, including the government spending package, and including repatriation.
Jeff Buchbinder: Even in what we think is probably a reasonable worst case scenario for the tariffs, you still got more stimulus coming in. It's a near 20 trillion dollar economy. This economy is very strong and we think strong enough to offset the impacts of the tariffs. At least based on the way we see them playing out at this point.
John Lynch: Sure. Of course, we're gonna have recession someday. We always do. But when you look at how this ... the momentum behind the fiscal tailwinds, we think, can certainly offset the tariff headwinds.
John Lynch: Another thing. I don't know if we do a good enough job emphasizing to investors, but Jerome Powell is obviously the head of the Federal Reserve, but the Vice Chair has a pretty big role also, Randal Quarels. He has been an advocate of reducing the stress on the stress tests for the major lending institutions. Studies we've seen have seen low-ball estimates of an additional 200 billion in lending capacity just by the reduced tier 1 capital ratio amount.
John Lynch: That 800 billion you're talking about with improved lending capacity suddenly is a trillion dollars, and that could be out-performing the tariff headwinds by a factor of five over the next 12, 18 months. I think that's something that investors really need to embrace because you get that sort of tailwind behind you.
John Lynch: Certainly we don't want to be dismissive of deficit spending risks and how the bond market will respond to an absence of Federal Reserve backstopping Treasury auctions to finance the deficit. But nonetheless, there are pretty impressive tailwinds there.
John Lynch: Moving on from policy, Jeff, you're our earnings guru. Let's talk about earnings in the third quarter. We're a week and a half into it and so far it looks like earnings are coming along real well.
Jeff Buchbinder: Yeah, they are, John. We're tracking about 22% year over year earnings growth, which is only a little bit better than where we were expected to be at September 30 when the quarter ended. But it's still real early. We're not even one fifth of the way done, even though that's great growth.
Jeff Buchbinder: When you look at the breadth of upside surprises thus far, the amount of upside surprises thus far, it does suggest we're gonna see more of a modest beat when all the numbers are in. We've gotten used to these really big upside surprises. The expectations, you know, five, six, seven percentage points. This one's probably gonna be more like two, maybe three. That could put us in the neighborhood of a 24% increase.
Jeff Buchbinder: I don't want folks to think that that's bad-
John Lynch: 24% is nothing to apologize about.
Jeff Buchbinder: That's a really strong increase. One narrative out there is, well this is a growth peak and it's only gonna get worse from here. Well, we have a long way to go between, call it 24% growth, and sub-seven, which would be the area that's below the long term average earnings growth rate. This cycle still has a ways to go, we think.
Jeff Buchbinder: As I mentioned up front, there's macro-indicators that suggest that this isn't just a quarter or two more of earnings growth and then we're gonna see earnings decline. We think any concerns about that are misguided.
John Lynch: Absolutely. We're bound to see peak earnings and headlines as this quarterly earnings season plays out. I think it's really important for investors to appreciate that we've seen 25% in the first quarter, 25% in the second quarter or so, call it 20-23%, 24%, this quarter. You're bound to see those sorts of headlines about earnings peak.
John Lynch: A couple of points on that. We did ... Actually, you did great work, you and Ryan partnered on this, talking about earning cycles. I guess we covered the last 10 or 12 earning cycles in our mid-year outlook, 'The Plot Thickens'. What we did there was really identify how long, what was the duration between a peak in earnings and when the next recession was.
John Lynch: What you guys found and what we found at LPL Research was that once earnings peak, it takes approximately four years before the economy slips into recession. Over that four year period, on average the market was up cumulatively north of 50%.
John Lynch: The whole idea that earnings have peaked, head for the hills, is clearly a mistake and not an appropriate investment strategy. Certainly not something we will be employing. I think that's one point we need to emphasize.
John Lynch: But also the duration of the profit cycle. We had profits essentially flat in '14, '15, and '16. The S&P Operating Earnings were probably 117 or 118 dollars. Didn't really move. And then we saw the good print last year. Certainly a much better print this year. Even if we see for the year of 20% earnings growth or so in 2018, we're still projecting earnings along the order of magnitude of call it a 10% increase on a year over year basis.
John Lynch: There may be some headlines saying, earnings growth is cut by half, but I still think that we should be emphasizing to investors that earnings can still be growing one and a half or two times their historical average next year. I think that's something that should keep investors focused on the fundamentals and not getting caught up on headline driven volatility.
John Lynch: What do you think about that, Jeff?
Jeff Buchbinder: I think that's right. Some of these leading indicators of earnings are really sending positive signals. The ISM Manufacturing Index is a big one. But also keep in mind that nominal GDP growth is tied to earning as well. That's real GDP growth, which is what's widely reported, plus the inflation rate. As inflation moves gradually higher, that gives companies pricing power that actually supports revenue growth.
Jeff Buchbinder: At this stage of the cycle, even if you don't get any margin expansions, because this is a very difficult time for companies to expand margins as wages rise and interest rates rise. Still, with buybacks and all the growth and the stimulus that we talked about, we could easily see 6, 7% revenue growth next year, potentially.
Jeff Buchbinder: That's a really strong environment for corporate America. You just keep margins the same and you're up 10% in earnings again.
John Lynch: And even keeping margins the same at 10%, that sounds like an out-of-body experience for me, because margins have been hovering in that area for four or five years now. Or three or four years. To the extent that we have to apologize for margins which are historically, what? How would you characterize that, Jeff? 5 or 6%, now that we're essentially not quite double that. Even if we decline by a point, that's something that I wouldn't view as fundamentally crippling for the profit cycle.
John Lynch: You mentioned earnings growth also. What are we seeing this year, maybe 8 or 9%? Even if we slip to 6 or 7%, it's not just tax cut driven, is it Jeff, on the top-line?
Jeff Buchbinder: No, definitely not. More inflation helps. A good GDP growth figure for next year certainly helps. But you've also got some potential for more growth in the energy sector and in financials. These are areas of the market that have been kind of depressed. The Wall Street lingo is, easy comparisons, right? We still have some easy comparisons here that-
John Lynch: 100% of nothing is still nothing, right?
Jeff Buchbinder: Yeah, they can work for us, right? Financials, in particular. We've been waiting for more loan growth there. We've been waiting for a steeper yield curve there. Those things haven't really helped earnings all the much yet, so there's clearly runway. Financials are expected to grow earnings 40% this quarter. That's one of the biggest sectors in the market.
Jeff Buchbinder: Energy, you alluded to it, at 90% or so this quarter. We're gonna see ... Oil's up around 70 bucks. That's 50% above, roughly, where it was a year ago. We're gonna continue to see solid earnings growth out of the energy sector here for a little while.
Jeff Buchbinder: And by the way, the dollar could weaken, and that is supportive of earnings. This quarter we're actually getting a tiny bit of a headwind against overseas earnings for US multinationals. You add in a tailwind from the dollar next year, and then it's very easy to see another double digit earnings rough year.
John Lynch: That's a good point when you talk about the dollar, because we've talked about this on recent podcasts, how Fed Chair Powell is not burdened by the expectations of a PhD in Economics. We think, while the Fed's official mandates are clearly price stability and insure as full an employment situation as possible, they have to be mindful of financial market volatility.
John Lynch: When you think about the emerging space, 85% of the world's consumers, all that, what is it, four trillion in dollar denominated debt taken out over the past decade? Powell cannot allow the dollar to get too strong, which would cause emerging currencies to get so weak, even if you strip out the crises with current account deficits in Argentina and Turkey, for example.
John Lynch: When you look at emerging Asia, for example, and just focus on that, food costs represent maybe a third of their consumer pricing measures, where it's only 10% here in the West. You've got debt interest servicing payments that the Fed has to be mindful of, whether or not it's part of their official mandate. And then you have to be mindful of capital flows as well.
John Lynch: I think they're on it, that they're not willing to make a policy mistake. They certainly don't want to cause a global financial crisis. We believe that the Fed won't be as aggressive as many believe next year. Consequently, that will be supportive of earnings going forward, and also we believe, supportive of the overall economy.
John Lynch: You talk about energy, you talk about financials. Energy's certainly been a beneficiary of regulation. Financials to some degree. But the aforementioned Jerome Powell clearly made that speech that you attended a few weeks ago, and when he said the US economy was remarkably positive, and market obsession switched literally in an instant from a flattening yield curve to a steepening yield curve and to the degree that yield curve continues to gradually steepen. That clearly is a benefit for the net interest margin, which is a prime driver of banks and the financial sector in the S&P 500.
John Lynch: So, Jeff, we're just about out of time. I do want to thank you for your participation. I thought you were very honorable, not gloating too much about the Kansas City Chiefs' win last night. We'll see if Ryan will recover enough to be back with us next week.
John Lynch: For all our listeners, pay attention to GDP this week. We've had a lot of volatility these last several weeks, and I think it's so important to focus on the fundamentals. If you see a 3-handle on GDP, 20-handle on earnings growth, anytime you see weakness, we think that's an opportunity. Particularly when you not only think of GDP, but think of some of the policy tailwinds we're seeing. Again, fiscal tailwinds offsetting tariff headwinds.
John Lynch: And then finally, just looking at the strong cash flow story, the strong revenue story, powering the strong earnings story for the remainder of 2018 and what we believe to be through 2019 as well.
John Lynch: So with that, Jeff, I want to thank you very much. Any closing comments for our listeners?
Jeff Buchbinder: Well, yeah, I just want to say we still like emerging markets. China is stimulating. They're talking about a tax cut today, that market up strongly overnight. Pay attention to emerging markets in China this week.
John Lynch: Absolutely. Great call out.
John Lynch: Everyone, thank you very much for listening. We greatly appreciate your participation, want to wish you a happy and safe week. We look forward to talking to you next week on the next edition of LPL Market Signals podcast.