 "Representative Image. Illustration by Binay Sinha")
The easy money may be over.
US company earnings growth is slowing after a bumper start to the year, and the reality of an escalating trade war between two of the world's largest economies is starting to weigh on companies ranging from Caterpillar Inc to Ford Motor Co.
While earnings growth is still high at 22 per cent so far this quarter, the amount by which S&P 500 index companies are beating analyst estimates is nearly half of what it was during the first quarter, according to Refinitiv data.
Along with rising interest rates which are making bonds more attractive, slower earnings growth is eroding investor sentiment and contributed to Tuesday's sharp sell in equities globally.
"These trade tensions are coming home to roost and they are impacting the fundamentals of the market," said Tally Leger, equity strategist at OppenheimerFunds. "Thanks to trade tariffs we are facing the headwinds of a stronger dollar, higher oil prices, and rising interest rates."
President Donald Trump has lauded the US stock market's rise during his presidency, but the market volatility comes at an inopportune time just two weeks before midterm congressional elections.
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Trump has focused on global trade policy in an attempt to revive US manufacturing.
But Caterpillar, the world's largest construction equipment maker, said before the US market opened on Tuesday that Trump's steel import tariffs, along with higher freight charges, cost it about $40 million in its most recent quarter. Shares of the company were down nearly 8.0 per cent in mid-day trading.
"The trade tensions are indeed pressuring corporate earnings and we possibly have been seeing a peak in earnings growth," said Sam Stovall, chief investment strategist at CFRA Research in New York. As a result, high market valuations could mean investors are not willing to pay as much for a company's earnings, he said.
The forward price to earnings ratio of the S&P 500 index was 16.2 as of Monday, down from a 2018 peak of 18.5 on January 22, according to Refinitiv data. At the same time, US companies are on pace to purchase more than $1 trillion of their own stock this year, according to TrimTabs Investment Research, and lower valuations could lure them to buy more.
Tax counterweight
The $1.5 trillion tax cut passed by the Republican party controlled Congress in December 2017 boosted corporate earnings earlier this year, and encouraged companies to repatriate cash parked overseas, but the tax cuts are now being offset by costs resulting from the new import tariffs, analysts said.
Among companies citing tariffs as a negative factor, 3M Co saw its shares fall nearly 6.0 per cent after its sales fell below forecasts by the most in 2 years and after it cut its earnings estimates due to a slowdown in China and rising tariff costs.
Ford Motor Company, which is expected to report its earnings on Wednesday, said in late September that steel tariffs have already cost the company $1 billion in profits.
Overall, the earnings growth rate of S&P 500 index companies peaked in the first quarter of this year at 26.6 per cent, according to Refinitiv data.
The third quarter is currently on pace for a 22.1 per cent growth rate, while earnings growth is expected to slide to a 9.0 per cent increase in the second quarter of next year as companies face tougher comparisons due to the tax cut boost in 2018. Other concerns for earnings include the stronger US dollar and rising interest rates.
Declining profit outlooks by other large companies could accelerate the sell-off, said Kate Warne, investment strategist at Edward Jones in St. Louis.
"Today you have got some big earnings misses and I think that has led investors to be concerned about will we continue to see solid earnings growth, especially with companies having beat the expectations but now saying the future doesn't look quite as good," she said.
