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US earnings season: playing the game

Investors have been enthused by hopes of tax cuts and an infrastructure spending spree, leading Wall Street to rally strongly since the election of President Trump. Optimism about the prospects for the US economy has also increased since November, although signs of an upturn in global growth – such as more positive responses to manufacturing purchasing managers’ surveys – were already emerging by late summer, before the vote took place. But while the surge in the equity market has – arguably – been largely fuelled by rhetoric and speculation, we are now almost through the first real Trump-era checkpoint for the health of the US corporate world: the fourth-quarter earnings season is drawing to an end.

So far, things look relatively encouraging. At the time of writing, 397 of the companies in the S&P 500 index have reported. Of these, more than two-thirds have beaten analysts’ expectations, according to research from Thomson Reuters. The financials sector has performed particularly well this time around: banks’ profits have been boosted by the beginning of a programme to return US interest rates to normal levels because higher rates allow them to charge more to lend funds. By contrast, energy and materials have disappointed, although the lingering effects of the slump in commodity prices appear to be waning. The anticipated figure for overall S&P 500 fourth-quarter year-on-year earnings growth sits at just under 7.3%. This number isn’t too bad in a world where, at least for the moment, inflation is still low.

On the other hand, the number of companies to exceed earnings expectations for the fourth quarter may be slightly ahead of the long-term average, but it is still below that achieved in each of the last four quarters. This trend was also highlighted by the so-called surprise factor, which measures how much a company’s reported earnings per share (EPS) differs from the EPS analysts expected it to achieve. Currently, the collective surprise factor (again, according to Thomson Reuters) for the companies in the S&P 500 index is 2%; again, a number significantly below the level of the last four quarters. Taken together, these measures indicate that expectations may have started to become inflated.

it is important to consider the psychology behind earnings season and how the game works for its major players

Putting the figures aside for a moment, it is important to consider the psychology behind earnings season and how the game works for its major players. Investors in US equities tend to fixate on corporate results and there is a strong pressure for US companies to beat predictions. In non-recessionary times, it has become a golden rule that, on average, expectations must be exceeded. And when it comes to providing profit guidance (the companies’ outlook for the year ahead), chief executives have been known to indulge in some management of expectations. The phenomenon is particularly evident during the fourth-quarter earnings season, when it must be tempting to set targets that are easy to beat in the year ahead.

Conversely, analysts tend to be at their most optimistic at this stage, making any necessary downwards adjustments to their estimates over the course of the year. Generally speaking, sentiment about corporate earnings is best measured by the earnings revision ratio, which looks at the number of positive and negative changes analysts make to their earlier forecasts. Put simply, the ratio is a broad gauge of analysts’ attitude towards the prospects for corporate earnings. After many years of prevailing downgrades, the global ratio is now firmly in positive territory, which bodes well for the future profits of US companies.

Source: I/B/E/S Thomson Reuters DataStream, MSCI1

Reports and guidance for the year ahead look relatively positive, but not sufficiently positive to fully explain why the US equity market has rocketed ahead. It seems that investors have assumed companies will benefit from Mr Trump’s promised corporate tax cuts and have valued equities accordingly, whereas earnings analysts have been more guarded on the subject, perhaps assuming that any reforms will take time to be approved by Congress. In fact, their estimate for the average rate of corporate tax to be paid by S&P 500 companies for the calendar year 2017 is higher than the rate they predicted for the fourth quarter. (Both are considerably lower than the US headline corporate tax rate, which is among the highest in the world.)

While the analysts may have paid little heed to Trump and his policies in their tax projections, the same cannot be said of company management and its guidance for the year ahead. According to a survey carried out by the Wall Street Journal at least half of the investor events (such as conference calls) held in January by US-based blue chip companies made mention – either directly or indirectly –of Mr Trump, his administration or new policies. A third made reference to tax reform. This is unusual in itself, given that executives are typically reluctant to be drawn on their political views during these discussions.

The majority of the references were positive, although some stood out as questioning the unforeseen or inadvertent effects of the new president’s proposed policies. One widely-publicised, somewhat surprising consequence is the boost Mexican cement companies and builders have received on the back of his promise to construct a border wall between the two countries. But some of his reforms may generate unintended effects for large US domestic companies too. For example, McCormick & Co., which distributes spices grown near the equator, said that it hoped there might be a way around border taxes (Mr Trump has said he intends to penalise imports) for commodities that cannot be produced in the US. McCormick’s CEO joked that the company is unable “…to move the equator into the United States.” Meanwhile, an extremely strong US dollar could be a negative for companies that are net exporters – it will be more difficult for them to sell their wares abroad.

Overall, the underlying messages associated with this US earnings season have been positive. There is, however, an important caveat in that the Trump presidency is in its infancy and no one can predict the full implications of the new government’s strategies, since we are still uncertain to what degree he will implement those touted during the election campaign. And while global economic growth will undoubtedly boost equity markets and company earnings, we think that the improving worldwide trend is already being reflected in US share prices. Currently, they look somewhat expensive relative to their peers. As such, investors might find better value for their money in markets such as Europe or Japan.

Image credit: Ivary Inc. / Alamy Stock Photo

1The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis, should not be taken as an indication or guarantee of any future performance analysis forecast or prediction. The MSCI information is provided on an ‘as is’ basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the ‘MSCI’ Parties) expressly disclaims all warranties (including without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages (www.msci.com).

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