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Posted on MAY 1, 2017

Johnson Bank Wealth Weekly Investment Commentary | Monday, May 1

This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, SVP, Chief Investment Officer.

Beginning or End?

We are more than half way through corporate earnings season. Companies report their earnings on a quarterly basis and have been announcing good first quarter earnings growth and expressing optimism about their future expectations. The question is whether the growth rate will continue to accelerate or moderate as we move through 2017.

Corporate Earnings

About 60% of the companies in the S&P 500 Index have reported first quarter earnings. So far, the reports have been very good. Earnings growth (including both estimated and actual reports) is up 12.5%. If the pace of outperformance continues, this number could climb even higher. In fact, this is a global trend. Companies in the European Stoxx 600 Index have produced 23% earnings growth during the first quarter. We must admit that part of this double‐digit growth rate stems from the weakness at the beginning of last year, so the year‐over‐year comparisons are relatively easy to obtain. This will get tougher as we move through 2017.

We haven't seen double‐digit earnings growth like this since 2011. Corporate earnings have been sluggish for most of the last three years. It wasn't until mid‐2016 that the 500 companies in the S&P Index had aggregate earnings exceeding where they were in 2014.

Graph showing the S&P 500 change in forward 12 -month EPS vs. change in price.

Not only have we seen earnings improve, we've also seen companies beating their sales estimates. This is important because it means companies are improving revenue growth rates, which creates more sustainable earnings growth than the financial engineering of stock buybacks and special dividends. The low cost of debt has made it easy for companies to borrow money and use the proceeds to purchase back their stock, usually lifting its price. While these activities can lift stock prices, they don't create permanent value like rising revenues.

Companies have added $8.5 billion in profits during the first quarter. The majority of the growth — 44% — came from the industrial and financial sectors. Industrials have benefitted from a pick‐up in economic activity, as have financials. Later in 2016, interest rates began to rise, which helped financial companies with their interest earnings. However, there is another side to that rise that we need to keep in mind.

Economic Growth

When 2016 began, interest rates (i.e., the 10‐year Treasury) were near 2.25% and the Fed had just hiked the Fed Funds short‐term interest rate by .25%, its first move in years. As the year went on, rates declined, with the 10‐year yield moving down to 1.35% in July. At the same time, the rate of inflation was low and moving lower partly because energy prices had declined precipitously in 2015. By February of 2016, oil prices were at $25 per barrel, where they bottomed.

The decline in oil prices led to an energy sector debacle for earnings. Companies involved in the energy sector saw earnings collapse, causing weakness in the first quarter of 2016's numbers (which is why year‐over‐year comparisons are easier).

The combination of falling interest rates, declining oil prices and low inflation stimulated economic growth and allowed the U.S. economy to maintain a growth rate near 2% for last year.

Last Friday, we received the first look at the U.S. economy's growth during the first three months of this year. Real growth was up .7% versus an expectation of 1.2%. That half a point disappointment reflects something that has been going on for several weeks and gives us pause about the benefits of last year's stimulus continuing. During the month of April, many of the economic reports we received were disappointing. This caused alarm, because reports prior to April had been coming in better than expected.

While it's too early to call the economic rally over, we'll need to monitor how much acceleration we get in the second and third quarter. That is because over the last several years it isn't unusual to get weak growth in Q1. Since 2010, economic growth has averaged .9% in the first quarter of every year and then 2.4% for the remaining three quarters. We'll see if we get there this year.

One of the data points in last Friday's report provided some insight into the Fed's future action. It has indicated that it would like to see inflation at 2%. The economic report we received updates the Fed's preferred method of tracking inflation. The Personal Consumption Expenditures deflator was up 2.4% and the core rate (excluding food and energy) was up 2% — in other words, right on target. This was also higher than the 1.3% we saw in the last quarter of 2016.

This level of inflation supports the Fed's recent moves and also suggests that the benefit of low inflation from the beginning of last year may wane as the year goes on.

One area of inflation to be particularly thoughtful about is wage inflation. In last Friday's report we saw that the employment cost index was up .8% for the quarter, 3.2% annualized. This increase in wage inflation can be troubling for earnings growth. Most companies have a substantial portion of expenses in labor. When wage growth accelerates, profit margins get squeezed.

While we are excited about the double‐digit earnings growth we are seeing in the first quarter, we are cautiously optimistic about the rest of the year because some of the tail winds we had last year have reversed. That leaves us wondering if this is the beginning of a new pattern of higher earnings growth that will last years or if we are nearing the end of a period that will last months.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

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