It's that time in the quarter again: 3Q earnings season begins this week with Wall Street consensus expecting S&P 500 EPS growth of just 5% (3% ex-Energy), a sharp drop from the last two quarters (Q1 was+14% and Q2 +11%). According to Goldman's Davis Kostin, "solid economic activity coupled with a weak USD will support sales growth of 7%, consistent with the past two quarters." The Goldman strategist also expects margins to slip slightly to 9.7% but remain near record highs, and that "investors will ignore the EPS slowdown given one-time hurricane effects and the focus on benefits from corporate tax reform."
Before we summarize the three main issues Goldman's clients are most focused on, here is a quick backdrop of the bank's overall outlook on the market:
S&P 500 notched another all-time high this week. Optimism for tax reform has pushed stock prices up despite bond yields rising to 2.4%. Our political economist assigns a 65% likelihood that tax legislation will be passed in 2018, which is consistent with market pricing. In late August, the S&P 500 traded at 2450, 17.6x our 2018 EPS estimate of $139. Details of tax reform are uncertain, but we estimate that EPS could rise to $148 depending on the final legislation. Applying a constant P/E multiple to the higher EPS would suggest an index level of 2610. The current S&P 500 level of 2550 implies a roughly 60% probability of corporate tax reform.
Incidentally, Goldman still expects the S&P 500 to end 2017 at 2400, 2018 at 2500 and 2019 at 2600, which means that the US stock market is just shy of Goldman's 2019 price target.
With that in mind, we look at the next big catalyst for the stock market, Q3 earnings season which begins next week, when several large-cap Financials will lead the way (BLK, JPM, C, BAC, WFC, PNC, and PGR). 89% of S&P 500 equity cap will report results by November 3. The initial thing to note is that contrary to historical patterns, strong economic activity during 3Q and strong 1H 2017 results explain the less negative EPS revisions than in the past. Consensus bottom-up S&P 500 EPS estimates for 2017 and 2018 have been trimmed by just 4% and 1% since March of the prior year, compared with an average cut of 10% and 3%, respectively, at comparable points in time since 1985
Looking forward, consensus expects S&P 500 EPS will grow by 5% year/year in 3Q, a substantial deceleration from 1Q (+14%) and 2Q (+11%). Excluding the rebound in Energy earnings (+128%), S&P 500 EPS is expected to grow by just 3% (vs. 10% in 1Q and 8% in 2Q). The slower expected pace of growth in 3Q 2017 partly reflects base effects, as S&P 500 EPS in 3Q 2016 increased after declining during the previous three quarters (see Exhibit 1).
The slowdown in EPS growth is forecast to be broad-based, but particularly pronounced in Financials. Financials EPS is expected to fall by 3% in 3Q, compared with a 21% increase in 1Q and a 10% rise in 2Q (see Exhibit 2).
According to Goldman, "weak loan growth and trading activity, along with hurricane-related losses, will weigh on Financials results despite another Fed hike and higher interest rates. Earnings are expected to decline in two other sectors: Consumer Staples and Consumer Discretionary.
Info Tech (+11%) is forecast to deliver the fastest EPS growth, driven by strong top-line growth (+15%). Margins are expected to decline in most sectors. Consensus forecasts that only Energy (+187 bp), Telecom Services (+38 bp), and Materials (+13 bp) will expand margins in 3Q. In aggregate, S&P 500 margins are forecast to decline by 5 bp to 9.7% (14 bp decline excluding Energy). However, S&P 500 margins would still remain near all-time highs."
That said, Goldman expects that given the low bar for 3Q earnings and solid economic data, the average EPS surprise will be modestly positive, but smaller than the beats in 1H 2017.
Kostin then lays out the three key, most recurring issues brought up by Goldman's clients ahead of Q3 earnings start:
- 1. Economic growth: Economic activity is the primary driver of S&P 500 sales and earnings. Our US Current Activity Indicator (CAI) averaged 3.0% during 3Q and the ISM indices reached multi-year highs, although our US Economics team expects 3Q GDP grew by just 2.0%, reflecting a one-time hurricane impact. Several firms (DRI, FDX) that have already reported results have also noted a modest drag on EPS from the hurricanes. The EPS impact will be particularly high for Insurance firms. Last week, Chubb (CB) stated that its losses from the hurricanes could total as much as $1.3 billion. Consensus expects Insurance EPS will fall by more than 30% in 3Q 2017. We expect investors will look through a slowdown in 3Q earnings due to one-time hurricane effects and heightened focus on tax reform. 3Q EPS estimates have already been cut by 2% in the past month and insurance companies most affected by the hurricanes have underperformed the S&P 500 by 300 bp in the past 2 months. Instead, investors will focus more on the upcoming milestones for tax reform, particularly in late October when the House and Senate must reach an agreement on the FY18 Budget Resolution.
- 2. Input costs and margins: Today’s jobs report showed average hourly earnings growth accelerated to 2.9% in September. The GS wage survey leading indicator stands at 2.8%. Qualitative measures, such as the Fed Beige Book, reference tight labor markets and wage pressures. Investors also appear to be rewarding firms less exposed to rising wages. Our basket of stocks with the lowest US labor costs (GSTHLLAB) has outperformed the S&P 500 by 4 pp YTD (+20% vs. +16%). In addition, the 3Q rise in materials input prices, such as oil and copper, may act as an additional headwind to margins in 3Q (see Exhibit 3).
- 3. FX and sales: For the first time since 2012, the trade-weighted US dollar (TWD) is weaker on average year/year. A weaker USD will support sales growth of 7% for S&P 500, in line with the pace in 1Q and 2Q. Historically, changes in the US dollar are tightly linked to sales surprises (Exhibit 4).
The 2% year/year decline in the TWD in 3Q suggests above-average positive sales surprises. Each 10% change in the TWD impacts S&P 500 EPS by roughly $3. However, the US dollar has recently rallied on the prospects of fiscal stimulus and a tightening Fed and may be a drag on S&P 500 sales going forward.