Publicly listed U.S. corporations will start to report second quarter earnings this week, which should provide some helpful insight into potential areas of weakness in the economy. S&P 500 earnings growth year-over-year (YOY) in Q1 was negative, the first decline since Q2 2016. Estimates for YOY growth in Q2 2019 as of July 12, 2019 are -2.7%. If actual earnings are in-line with estimates, this would be the first consecutive quarters of negative earnings growth since Q1 and Q2 of 2016.
FactSet noted that companies with more than 50% of their revenue derived from outside the U.S. are expected to be the driver of the negative earnings growth in Q2 (-10.7% vs. 1% for companies with less than 50% foreign revenue exposure).
One of the industries that is expected to have the largest decline in earnings in Q2 is the Technology sector, which is understandable considering it has a large amount of international revenue. Technology has been the best performing industry year-to-date (YTD) and over the last twelve months. If their profitability starts to decline, this could become a headwind for overall S&P 500 performance.
We are also interested in company guidance for the second half of 2019 and calendar year 2020. Estimates for calendar year 2019 earnings have been declining for several months.
Current analyst estimates for earnings growth in calendar year 2019 are 2.4%. As discussed in prior posts, leading economic indicators globally and within the U.S. have been declining for several quarters. We expect this to eventually lead to weaker earnings, partially from slower revenue growth.
Analyst estimates for Q2 and calendar year 2019 revenue growth are 3.7% and 4.3%, respectively. If realized, the 3.7% revenue growth rate would be the lowest YOY growth rate since Q3 2016. Again, Technology is expected to have weak revenue growth in Q2, as are other areas with high foreign sales exposure (-2.2% vs. 6% for companies with less than 50% foreign revenue exposure). Guidance on revenue growth will provide a measure of what companies believe economic growth will be and a gauge on how much pricing power they can exert.
The earnings growth estimates mentioned above are calculated based on S&P operating profits per share. However, there are other ways to measure corporate profitability. One common calculation is profits from current production, which come from the national income and product accounts (NIPA). NIPA data vary from S&P 500 operating profits in a few ways. NIPA profit data is calculated by the Bureau of Economic Analysis on all U.S. based corporations (not just those in the S&P 500), based on profits from current production. This means that dividends and capital gains are excluded from income and bad debts and capitals losses are excluded from expenses. NIPA profits can be viewed before or after taxes and with or without inventory valuation (IVA) and capital consumption (CCA) adjustments. NIPA profits before tax and with IVA and CCA adjustments are used in the calculation of Gross Domestic Income. National after-tax profits without IVA and CCA adjustment are conceptually closest to S&P 500 profits since S&P 500 profits measure the after-tax worldwide earnings of U.S. corporations. Looking at the most recent NIPA data, we can see that profit growth using this measure has been weaker than S&P operating earnings. After tax profits with the IVA and CCA adjustments grew at just 2.4% on a YOY basis in Q1 2019 and was negative on quarter-over-quarter basis. On a pre-tax basis including the IVA and CCA adjustments, NIPA profits have declined for two consecutive quarters and peaked in Q3 2018. On a pre-tax basis without the IVA and CCA adjustment, profits peaked in Q3 2014 and are at the same level they were in Q1 2012. Among other things, this highlights the positive impact share buybacks have had in this cycle.
We believe this earnings season could be an important pivot point in determining if this is the end of another slowdown period in a record long economic expansion, or the start of a longer-term downturn. We intend to continue to provide updates as we receive more earnings reports and company guidance.
Rank Dawson, CFA
Vice President, Research and Strategy
Boyd Watterson Asset Management, LLC
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.