Company profits exceeding expectations

Share prices have performed well so far in 2019. By the end of April, the FTSE 100 index was more than 10% higher than at the start of the year, while the main US index of share prices (the S&P 500) was up nearly 18%. However, during May some investors became concerned the good times would soon come to an end. This was partly due to fears that trade discussions between the US and China would break down, with damaging implications for the global economy.

But some of the concern also related to corporate profits. In the US, companies had delivered average annual profits growth (as measured by profits per share) of 20% in the second half of 2018. Analysts decided there was little chance that such a pace could be sustained and significantly downgraded their forecasts. If companies are making lower profits, they won’t be able to redistribute as much to investors in the form of dividends. This makes their shares less attractive, causing prices to fall.

The downgrades were particularly pronounced in certain sectors. Many technology companies, such as Facebook and Apple, warned investors that increased regulations could lead to lower profits. Analysts adjusted their forecasts accordingly.

All in all, the consensus expectation was for US company profits in the first three months of 2019 to shrink by 2.8% compared to the same period last year.

Technology companies beat forecasts

But those reduced expectations have been confounded. Profits generated in the first three months of 2019 have generally been good, with around three-quarters of the S&P 500’s constituents reporting better profits than analysts’ expectations. This significantly exceeds the historic average: typically, only two-thirds of companies announce positive surprises.

Analysts have revised their expectations upwards and now expect positive profits growth for the rest of the year.

Investors reacted favourably to the surprises. For example, shares in Facebook increased in value by 8% on the day it announced its results. Investors were even undaunted by the company setting aside $3 billion for the Federal Trade Commission’s privacy-related investigation. Although a fine of this size would be a record, it means relatively little to a company holding $42 billion in cash. Announcements from other technology giants were also positive, with the exception of Alphabet (Google’s parent), which failed to meet expectations.

Companies have also been buying back their own shares. This often has a positive effect on share prices, as the earnings per share figure, which is one of the measures used when valuing companies, goes up.

Financial and technology companies – most notably Apple – have been among the biggest buyers of their own shares. This indicates they won’t need the money for other purposes, and that they are confident about their future prospects.

The buyback trend looks set to continue. The effects of these buybacks can be seen in company share prices. Apple’s shares leapt 5% after it committed to buying back $75 billion of shares.

Can profits grow further?

The big question investors face is whether profits have now peaked. Our analysis suggests that US companies in particular are reaping the benefits of lower corporate taxes and low interest rates. They are taking advantage of cheap borrowing and investing the money in ways that are generating future profits.

One threat could be wage increases, given that the US unemployment rate is at a 50-year low. We don’t think, however, that there is anything immediate to fear here. In 2018, the prices companies were able to charge rose faster than wages, implying higher profit margins. A fear that wage increases will derail corporate profits looks misplaced.

Chinese economic policies help

Besides the improvement in confidence, efforts by the world’s central banks to boost demand are helping to stabilise investor confidence. This has been a major factor in this year’s strong performance by equities.

These policies are leading to improvements in economic activity. In particular, the Chinese government’s policies should help to maintain global growth. Some economists had feared that slowing Chinese growth could cause a global slowdown, but these concerns are giving way to expectations of increased economic activity.

We also expect US consumers will carry on shopping – an important component of global demand. We base this view on two factors: first, the US jobs market remains strong; and second, US consumers have benefited from cuts to personal taxes and lower mortgage rates.

We expect profits to improve further in the second half of 2019. There are always caveats, of course: further developments inthe US-China trade war could pose risks, as we saw in May. But we think strength in company profits will continue to support shares prices, making them a more attractive investment than other assets, such as bonds and property.

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Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise. No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.

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