Ok, so we’ve spent a ton of time over the past six months talking about peak earnings and peak margins.
It’s no secret that Trump’s tax cuts and stimulus bolstered corporate bottom lines in 2018 and everyone (with the possible exception of Larry Kudlow) knows that the fiscal impulse is going to fade in 2019.
Generally speaking, the consensus is that Q3 marked something akin to “peak earnings growth” and everyone expects a sharp deceleration on that front in 2019. Further escalations on the trade front would make the situation worse.
What nobody seems willing to admit (thus far anyway) is that an actual earnings recession may be in the cards.
It’s somewhat odd that folks are loath to raise the issue considering the trio of gale force margin headwinds on the horizon. Those headwinds are: wage inflation, rising rates and tariffs.
Read more on the “terrible trio”
Despite the very real prospect that corporate profitability could face substantial erosion going forward, consensus is actually calling for further margin expansion in 2019.
One person who takes issue with this is – you guessed it – Morgan Stanley’s Mike Wilson, the man who called the Tech selloff and who was out on Monday with his year-ahead U.S. equities outlook, which is garnering a lot of attention in light of how prescient Mike’s calls have been in 2018.
Read more
Mike’s Back: Analyst Who Predicted Tech ‘Rain Storm’ Releases 2019 U.S. Equity Outlook
In the course of documenting Wilson’s bull, bear and base case scenarios for the S&P, we noted on Monday that his bear case (SPX 2,400) revolves around an earnings recession in 2019.
“The recent strong run of growth we have seen in earnings may have lulled the market into complacency on the forward outlook, but with decelerating topline and building cost pressures, we are highly confident that earnings growth will be below consensus expectations next year and believe there is elevated risk of an outright earnings recession”, Wilson writes, before reminding you that “topline growth, and margin expansion, have been driving underlying earnings growth, with a boost from lower taxes in 2018.” Here’s the breakdown on that:
(Morgan Stanley)
Clearly, shrinking margins and/or decelerating sales growth would be a real issue.
On that latter point, Wilson reminds you that GDP growth will slow meaningfully in 2019 and contrary to what you might have heard from the administration, that is a foregone conclusion. “Given that we will be lapping the boost from fiscal stimulus this year, we do not think this is a controversial statement”, Wilson flatly states.
The real issue for revenue growth as GDP slows is that corporate toplines are more sensitive on the way down than they are on the way up or, as Wilson puts it, “corporate topline growth has a higher beta to decelerating GDP growth than to accelerating GDP growth.”
(Morgan Stanley)
Long story short, consensus isn’t pricing in that difference in sensitivity.
On margins, Wilson is a bit incredulous at just how sanguine the market appears to be about headwinds to profitability. That sanguinity is manifesting itself in projections for margin expansion across every sector but one. Here’s Mike:
Exhibit 5 shows the spread between sales and net income growth (adjusted to exclude the effects of tax cut growth), or margin expansion, for the S&P 500. Based on current consensus estimates, this spread will remain above the historical average over the last several years as we head into 2019, getting more extreme as the year progresses. Not only is consensus baking a third consecutive year of margin expansion into estimates, but the magnitude of that margin expansion also looks high by historical standards and is spread across almost every sector.
Obviously, slowing sales growth would only serve to exacerbate margin pressure and in that regard, Wilson frets that “there is an elevated risk that companies are making budgeting decisions based on their current operating environment, meaning that sales missing expectations creates the potential for operational deleveraging that may provide an additional pain point for margins beyond those from rising costs.”
Morgan goes into (much) more detail, but as you’ve hopefully surmised, this really isn’t that complicated. Projecting ongoing margin expansion in an environment where margins are already fat, wage inflation is starting to show up, rates are rising (against a backdrop of high corporate leverage) and the U.S. is slapping tariffs on anything and everything, is a rather tenuous proposition.
Equally tenuous are rosy projections for topline growth against a backdrop where GDP growth is guaranteed to slow, if not because the economy is doing “poorly” per se, then simply because it was doing so well that the only place to go from here is lower (on growth).
Wilson sums all of this up nicely with one formula which we’ll present without further comment:
Sales Miss + Margins Miss = Earnings Recession?
Is this sort of how like physicists cannot know what the weather will be like in two weeks because it is a dynamic system with too many variables, but can make predictions about what the universe will be like in 70 billion years?
“In a complex system, the interplay between the variables is much more important than the change in any single variable” – Prof. Steve Keen
Although in this case a couple of the variables are misunderstood – wage inflation is really a chimera – it’s only a problem in the ‘mind’ of The Fed – but in turn can make it a big problem for everyone else! Tariffs aren’t harmful to aggregate economic grow (although they can create short term disruption) BUT they are harmful to the biggest beneficiaries of so-called ‘free trade’ – i.e. the USA.