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The 3 Most Important Things Investors Need To Know About This Earnings Season

Posted On October 18, 2018 9:21 am
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What Wall Street Will Be Watching Most Closely

Source: FactSet Research

When it comes to risk factors that companies are talking about in conference calls the three most pressing concerns are a strong dollar, rising input costs, and tariffs.

The strong dollar is a major concern for multinationals for two reasons. First, if the dollar appreciates relative to other currencies (up 5.1% in last 6 months) then US products and services become more expensive overseas. Foreign sales also translate into lower US dollar denominated results, creating negative growth headwinds. The dollar appreciates if foreign demand for dollar assets rises, such as from foreigners buying more high-yielding treasury bonds (relative to record low rates overseas), as well as invest in the strong US economy. With growth in the UK, EU and Japan much weaker than in the US, this is indeed a valid short to medium-term concern.

Source: FactSet Research

Meanwhile rising raw material and wage costs are a potential threat to the steady increase in corporate profit margins that companies have enjoyed since the Great Recession ended. This is what allowed modest revenue growth to translated into much stronger EPS growth (14.3% CAGR) since 2009. However, we need to remember that margins will get a permanent boost from corporate tax rates falling from 35% to 21%.

Recent inflation reports, including for wholesale prices (what companies pay for raw materials), have been showing easing pressure in recent months. What about wage growth due to the tightest job market in 20 years? Well the Atlanta Fed tracks median wage growth and the numbers for August show 3.5% YOY growth compared to 3.2% in July.  That continues the historical trend of gradually rising wages since April 2011, when wage growth bottomed at 1.6% YOY. However, it’s important to remember that historically wage growth during a healthy economy has averaged between 3.5% and 4.0%. The most recent Job Openings and Labor Turnover Survey (JOLTS) report showed 7.14 million job openings compared to 6.23 million workers looking for jobs. That approximate 900,000 worker shortage, plus a 13% increase in the number of workers voluntarily quitting (because of higher paying jobs lined up), indicates that wage growth should indeed continue rising.

In fact a recent survey of small businesses shows that about 34% of them plan to raise wages in the next year. That’s the highest level ever recorded. But remember that until wage growth actually hits 4.1%, corporate earnings are not likely to be negatively impacted. That’s because there are two major benefits to strong wage growth. The first is most intuitive. More people working for higher pay means consumers have more money to spend. Since 65% to 70% of the US economy is derived from consumer spending, this means that rising widespread prosperity is a good thing for the economy in general, and companies who benefit from rising sales, in particular.

The less intuitive benefit of rising wages (and higher demand) is that companies have increased pressure to invest in productivity boosting capex. New more efficient (automated) capacity means that new and existing workers become more productive, thus sales per employee rises, unit prices fall, and inflation pressures in general decrease. In addition rising worker productivity means that rising wages don’t stoke inflation, allowing the Fed to avoid hiking short-term rates to levels that risk causing a recession.

Better yet, due to lower corporate tax rates the returns on new investments have now been permanently increased. What’s more, through the end of 2022 companies can write off new capex right away, thus creating even greater investment incentives. Ultimately long-term economic growth is a function of labor force growth (number of workers) and productivity (how much each worker produces). Thus rising wages from a tight labor market are actually a long-term boost to growth. That’s because rising wage pressure combined with growing demand forces companies to become more efficient and competitive. 

What about rising interest rate fears? Well as you can see in the above table, rate fears are the smallest concern for large companies. But here too there is a benefit to higher short-term (what Fed indirectly controls) and long-term rates (which are determined by bond market, not the Fed). Record low interest rates for so long have allowed the number of zombie companies to rise 500% since 1985. These are companies whose earnings before interest and taxes (EBIT) doesn’t cover their debt service costs. Or to put another way, these are companies that in a normal rate environment would have died out long ago (like Sears). Their assets would then have been sold at pennies on the dollar to healthy and better run companies that could put them to better use. This is the creative destruction that healthy capitalism is based on, and leads to rising productivity and a more prosperous society over time.

According to Deutsche Bank the number of zombie firms in the US peaked in 2016, when 2% of all US businesses were being kept afloat by ridiculously cheap credit. In 2016 the oil crash washed out some of them, and in 2017 continued increases in interest rates killed off even more. The death of zombie firms isn’t a threat to the economy, since these companies are not net job creators. In fact, publicly traded zombie corporations make up just 10% of all US stock market cap, according to the Bank of International Settlements, which has tracked zombie firms for decades. This means that even if every zombie firm in America were to go bankrupt tomorrow the US stock market would fall about 10% as a result. That’s a standard (and historically mild) correction, not a crash. In reality, long-term interest rates are likely to peak relatively soon (about 3.3% to 3.4% for 10 year yield and 3.5% for 30 year yield), according to current bond market futures and 30 years of bond market history. Short-term rates are also likely to rise no more than 0.75% (3% Fed Funds rate peak in mid 2019 according to bond futures).

What that likely means for corporate earnings is that a few highly leveraged and poorly run companies might face increased pressure, especially when it comes to refinancing their debt. That’s because, according to Moody’s, the amount of junk bonds maturing will rise 10 fold through 2022. 

But assuming the bond market is right that long-term rates will peak soon, and short-term rates rise only another 0.75% or so, then this actually creates a “goldilocks” scenario for US corporations and the economy. That’s because slightly higher long-term borrowing rates will force healthy companies (which dominate the S&P 500’s market cap) to become more disciplined with debt. The poorly run zombie firms, kept alive by super cheap junk bond yields, will face mounting extinction pressure. This will actually help America avoid the fate of Japan, where near continuous money printing and cheap credit since 1990 has made that economy decrepit, stagnant and mired in nearly 30 years of very slow growth.

What about the big fears over the US/China trade war? Well here there’s also good news. Specifically that current estimates (from the IMF) estimate that US economic growth would slow just 0.2% next year, if 25% tariffs go into place on all Chinese imports. China’s economy, per a report from JPMorgan, is expected to take a 1% hit. Since that would lower growth to 5.5%, below the 6% that the government has stated is the minimum needed to maintain political stability (Communist Party remain in power), it’s likely that China will soon cut a deal with the US that will end the trade war.

That’s because Beijing has already announced a $175 billion economic stimulus plan to counter growth that’s been slowing for years (long before the tariff fight began). US tariffs on Chinese imports have barely even begun and won’t really kick in significantly until 2019. If China is already launching emergency stimulus now, then that’s an indication that they will not likely be capable of withstanding a full year of escalating tariffs (up to 25%) on all exports to the US.

Ok, so the outlook for US corporate earnings is actually better than many fear/expect. But what should individual investors focus on during earnings season?  

About author

Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I'm a proud co-founder of Wide Moat Research, Dividend Kings, and the Intelligent Dividend Investor. My work can be found on Seeking Alpha, Dividend Kings, iREIT, and the Intelligent Dividend Investor. My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives. With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams and achieving long-term financial goals.

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