The 1Q earnings season is very strong on both a beats and growth perspective. 87% of the S&P 500 by earnings weight has reported. The weighted average earnings-per-share (EPS) beat is 7.6%, which compares to the 3.4% average beat since 2011. Every sector reported better results than expected. Bottom-up 1Q EPS is up 24.9% year over year (y/y), which compares to average EPS growth of 7.5% since 2011. Even excluding the tax benefit (8-9%), 1Q EPS growth is still excellent. However, the market appears unenthusiastic as the S&P is down since the beginning of reporting. Many possible reasons are quoted such as macro data softening from high levels, the end of analysts' earnings upgrade cycle, peak-margin worries, looming inflation and interest-rate-surge concerns, uncertainty on Fed hikes beyond 2018, trade-tariff threats, etc. In our view, most of these concerns are exaggerated and unlikely to materialize into real threats. We are optimistic on U.S. equities and our "next 5%+" S&P 500 tactical call remains "Up".
We think analysts were reluctant to include the full tax-cut benefit in their 1Q EPS estimates, rather waiting for an indication this earnings season. That’s why the overall beat is much higher than many expected. Bottom-up (Btm-up) 1Q EPS is now $38.52, much higher than the $26.00 consensus going into the earnings season, and even slightly above our long-standing $28.00 estimate. 1Q EPS growth is tracking up 24.9% y/y. To break it down, pretax-income growth is 14.9%, given a 1-2% boost from buybacks, the implied tax benefit is 8-9%. If we annualize 1Q EPS, it’s $154. We see upside to our 2018 whole-year EPS estimate of $155. It’s more likely to be close to $160 if Fed hikes 2 more times, oil stays ~$65 and dollar doesn’t surge from here.
In 2012, the S&P 500 net margin reached the previous cycle high of 9.3% in 2007. Ever since, many have voiced worries of margins being unsustainable. Our long-held view is that the S&P net-margin expansion since the mid-1990s is sustainable for many structural reasons: (1) S&P constituent changes (~5% annual constituent turnover); (2) lower effective tax rates as S&P foreign profits doubled since the mid-1990s, and now a lower U.S. statutory corporate tax rate; (3) less net debt and lower interest rates reduce interest expense; (4) higher-margin businesses expanded abroad causing higher margin sectors and industries to be a bigger share of S&P earnings. It’s also important to realize that despite the S&P’s rising net margin since the mid-1990s its aggregate ROE remains in line. Theory supports return-on-capital mean reversion, not margins. Since 2012, the S&P net margin set a new record every year except for 2016, due to the crash in Energy profits. On current constituents, the S&P’s pro-forma net margin was 11.0% in 2017. Now with the new 21% U.S. corporate tax rate, 1Q18 btm-up S&P net margin rose to 12.3%.
Both S&P net margins and the U.S. unemployment rate are very cyclical. Historically, S&P net margins are near their peak just before the start of a recession and unemployment near its low. This peak in margins and trough in unemployment are only clear in hindsight after a recession starts. Past recessions have come with very different margin peaks and unemployment troughs at the start. S&P net margins normally rise when average hourly earnings rise, which is largely due to higher employee productivity that occurs when businesses get to higher capacity utilization of fixed assets and other economies of scale. It is unit labor costs (ULCs) that are a better indicator of margin pressures, and right now ULCs are benign. ULCs are a better measure of broad-based inflation and currently remain below Fed’s 2% target being up only 1.1% in 1Q18. We don't think wage growth will hurt S&P margins unless ULCs rise significantly above 2% y/y.
Higher oil and commodity prices usually benefit S&P net margins as the S&P is more a commodity producer than consumer. Also Fed hikes, especially early-cycle hikes occurring when the overnight rate is still below the neutral rate, are normally accompanied by rising S&P margins. We think the S&P’s net margin will remain at current levels until the next recession.
Australia has taken the record for the longest economic expansion at 26 years since 1992. We also note that the UK, a mature service-consumption-driven economy like the United States, had a 16-year expansion from 1992 to 2008. Although this current U.S. expansion is 9 years old and the U.S. record is 10 years from 1991 to 2001, we see no good reason for a recession anytime soon. Even if growth is slow in the coming years, the U.S. economy should be resistant to shocks owing to its lesser sensitivity to inventory, capex and credit cycles. The U.S. is less dependent on foreign oil and thus less susceptible to geopolitical shocks. The Fed will have room to cut rates from the 2.5%+ level likely in the coming years and the Fed does have other tools to stimulate if inflation is not a threat. The external threats to the U.S. appear benign given economic conditions globally, particularly given the respectable growth in Europe and Japan and the soft landing China has engineered in its curtailment of credit-driven investment spending.