Two important headwinds for earnings are fading for now—oil prices have rebounded and the dollar has weakened from the start of the year. But despite expectations for a second-half earnings recovery, the potential upside for US equities is limited in the months ahead given stretched valuations.
First quarter reporting season for US equities is nearly over, and, as expected, earnings results were weak. S&P 500 operating earnings per share (EPS) declined an estimated 7% year-over-year, the fourth consecutive quarter of declines. The twin trends of low oil prices and a strong dollar combined to weigh on company earnings across most sectors.
Not surprisingly, energy sector financial results have been decimated in recent quarters, culminating in first quarter operating earnings swinging to an aggregate loss. The IT sector, with nearly 60% of sales generated outside the United States and over one-third of profits earned in other currencies, has felt the brunt of the strong dollar, with earnings falling roughly 6% in first quarter 2016. Financials saw first quarter EPS decline 12%, as market volatility associated with the large moves in crude and the dollar hurt trading- and asset-based profits for banks and investment income for insurance companies. Other sectors connected to the commodity complex and exposed to the strong dollar, namely materials and industrials, have also suffered consecutive quarters of EPS declines.
To give a sense of the extent to which the oil price collapse, strong US dollar, and sluggish global demand have weighed on S&P 500 results, a recent analysis by FactSet compared estimated first quarter financial performance for companies more domestically focused (US revenues greater than 50%) with stocks more exposed to international markets (US revenues less than 50%). The results are telling—for the S&P 500 overall, first quarter year-over-year EPS growth of the most domestically focused companies was estimated to be 15 ppts better than that of the most internationally exposed stocks, -4% versus -19%. US-focused companies were also expected to see positive revenue per share growth, compared with sharply negative sales growth for the rest of the index. And excluding the energy sector, stocks with greater than 50% US revenues are estimated to have experienced flat EPS growth last quarter versus a double-digit decline for their more globally oriented counterparts.
The potential good news for near-term forward earnings is that the headwinds of weak oil prices and a strong dollar show signs of abating. The dollar has given back some ground versus other major currencies since late January, coinciding with more dovish commentary from the US Federal Reserve. Meanwhile, crude oil prices have rebounded over 80% from their February lows on production cuts and surprisingly resilient demand. If the average levels for oil and the dollar in second quarter to date hold up, headwinds to earnings from their prior powerful moves will be diminished, providing some relief to year-over-year earnings comparisons going forward. An end to the US earnings recession in the next one to two quarters appears possible given the combination of China’s recent economic stimulus, favorable trends in oil supply/demand, improving US consumption data, and hesitance on the part of major central banks to adjust their policy stances in the near term.
As a result of these developments, current consensus estimates for a second-half US earnings recovery appear reasonable, with the latest forecasts for flat EPS growth for full-year 2016 and 13%–14% growth in 2017. The market already appears to be pricing in this scenario given the S&P 500’s 12% rebound from its February 11 low. Set against the first quarter earnings declines, US equity valuations now look quite stretched—both the S&P 500 and the MSCI US Index traded at approximately 22 times normalized operating EPS as of April 30.
A return to earnings growth is required for valuations to return to more reasonable levels; until that occurs the market will remain vulnerable. A continuation of firmer oil prices and a weaker dollar should support an improved earnings picture, as would stronger US economic growth following weak first quarter GDP. The early signs are that second quarter output will see an improvement, but the US expansion remains sluggish to say the least. The Fed is helping—its reaction function appears more sensitive to global market dynamics and the strong dollar, and the Fed futures market is now discounting just one rate hike this year. Such an apparent dovish stance is certainly contributing to US equities’ levitation act, and were the Fed to reverse course and resume tightening sooner, it could be a negative shock for the market. A further bout of capital flight and currency volatility for China ranks as another vulnerability, as it would likely contribute to a renewed commodity sell-off and dollar rally.
Risks to US equities remain firmly skewed to the downside as a result, but as long as the Fed remains on hold and the twin earnings headwinds of weak oil/strong dollar continue to fade, US equities could continue to muddle along near recent levels.
Michael Salerno is a Senior Investment Director on Cambridge Associates’ Global Investment Research team.