Earnings growth in 2019?
Publicly listed companies in the US account for more than half of the world’s total by value(1). Those companies’ profits have benefited from the tax cuts implemented by President Trump’s administration. American companies spent several months in 2018 trading at or near record highs with Apple becoming the first company to be valued at more than a trillion dollars ($1,000bn).
US company shares are highly priced
Shares in the US are expensive relative to the value of the profits that they generate when compared with their European and Japanese counterparts. This is because the demand for US shares has been driven up as investors anticipated continued growth in corporate profits. However, there are forces gathering that are likely to start putting downward pressure on the rate of profit growth and, therefore, share prices.
Inflation is rising
As we have seen, inflation has been rising which is prompting central banks to reduce the economic stimulus that they provide.
As a consequence, interest rates are rising which makes borrowing more expensive and reduces the amount of money people and businesses have available to spend. This reduction in liquidity is being exacerbated by central banks pulling back on their bond buying programmes. These programmes injected huge amounts of cash into the financial system and helped to keep bond prices up in the years following the financial crisis. As central banks halt or reverse these injections, there is less cash in the system and that leads to increased inflationary pressures.
Another factor driving inflation up is rising labour costs. With unemployment at very low levels of around 4% in the US and the UK, and on a downward trajectory in Japan and the EU, employers are having to pay more to find the candidates that they need to fill vacancies.
Hourly labour costs in the eurozone rose 2.2% compared to one year earlier(2), the highest rate of increase since 2012. In the same month, US hourly earnings rose 2.9%, the fastest pace since 2009(3).
As well as higher wages, companies are likely to face rising import costs as the US renegotiates trade deals with a variety of international partners. All of these inflationary factors are likely to eat into the growth rate of corporate profits, putting downward pressure on share prices. It’s also worth looking a little deeper into which parts of the economy have driven growth and how the future looks for them.
Share prices of companies in the IT and consumer discretionary sectors have led rises over recent years. In the US, those two sectors account for around 40% of the country’s equity market, way above the rest-of-the-world’s 23%(4). This is partly why stock price growth in the US has outpaced that elsewhere.
Mixed outlook for share buy-backs
There are other factors that need to be taken into account. Over the past decade, companies listed on the S&P 500 index have bought back $4,400bn-worth of shares(5). This boosts the share price in question by offering shareholders a high enough price to entice sufficient numbers of them to sell their shares. It also reduces the number of shares among which company dividends are to be distributed in future, suggesting potentially higher dividends to look forward to.
If the company in question has cash to hand, then buying shares tends to make sense. But if the company is borrowing money to fund such buy-backs, then the interest rates on those borrowings has to be lower than the yield the company is paying shareholders for the transaction to make sense. Otherwise, it creates a larger financial burden for the company to carry into the future.
As we have seen, interest rates are rising and stock prices are high, so the volume of significant share buy-backs could fall, reducing the effects of what has been a positive driver of share price rises recently.
Our basic prognosis is that a recession in 2019 is unlikely but the rate at which corporate profits are growing could fall. But that is based on a continuation of the factors for which we can, to some extent, account.
1. US stocks accounted for 51.3% of global publicly listed stocks in 2017 according to Statista.com, information downloaded in October 2018.
2. Source: Eurostat website, accessed October 2018.
3. Source: Bureau of Labor Statistics website, accessed October 2018.
4. Source: MSCI Inc data quoted by BCA Research in “It’s all about earnings”, 7 September 2018.
5. Source: “Share buybacks have been helping keep the bull market afloat”, Business Insider, 25 September 2018.
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