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Insights / Blogs

On The Lookout

James Swanson, Chief Investment Strategist, helps readers make sense of the markets by sharing what he learns along the way.

April 21, 2015

Earnings Season's Greetings

Earnings have taken a hit from a combination of lower oil prices and a higher US dollar.
But similar episodes in history suggest that we may still have some clear sailing ahead.
Economic activity and equity valuations tend to pick up in the first phases of Fed rate cycles.

As earnings season commences for the first quarter, we’ve been thinking about the current slowdown and the interest rate trajectory — with the US Federal Reserve’s first hike still likely to occur later in 2015. What does this backdrop mean for equity valuations and earnings?

Economic data retrench
Measures of the US economy’s health have been decelerating, including a disappointing nonfarm payroll report for March. We suspect this slowdown is real — not just a function of the bad winter weather, but the confluence of a consumer spending minicycle, a drop in capital goods investment and a weaker energy sector because of depressed oil prices.

We have seen episodes like this before, when lower oil prices and a higher dollar have combined outside of a recession. Earnings take a hit for a couple of quarters — especially in the materials, industrials and energy sectors. Remember that energy is considered elastic, which means that it tends to invoke a demand and a supply response.

Typically about 12 months after such slowdowns, lower oil prices and the stronger dollar boost US consumer spending, and the rise in final demand pulls more economic activity through the system. S&P 500 revenues then rise, and the equity market follows suit. That’s one reason why we think the hit to earnings may be temporary this time too.

Equity analysts react
Furthermore, labor expense as a percent of S&P 500 sales has continued to fall, telling me that fundamental reasons — not financial engineering — are still supporting profit margins. Even though 2015 may turn out to be the weakest year for earnings so far in this business cycle, the situation could turn around again as long as unit labor costs remain relatively low in the United States.

Admittedly, the forward price-to-earnings ratio of the S&P 500 is a little bit elevated compared to historical levels, and Wall Street analysts are taking down their earnings expectations. But I think these revisions may be too radical. If we look at consumer discretionary, utilities and technology — the sectors that tend to do better 10–12 months after the price of oil falls — then we could see a pickup in earnings and economic activity later in 2015.

Fed policy calculus
The first-quarter slowdown has also been watched by Fed policymakers, who may be more willing to wait beyond June until September, or even later, to see better signs before the first rate hike of this cycle. Whatever the timing, we don’t expect a 25-basis-point increase in the target federal funds rate to hurt that many bond portfolios or, for that matter, have much effect on the real economy.

Most debt of companies in the S&P 500 Index is now fixed in the bond market, not in variable-rate debt with the banks. And US consumers have not been tapping their credit cards and taking out auto loans as much as they did in the three previous cycles. As a result, the Fed’s initial rate increases are unlikely to stem or curtail economic activity.

Wages are another thing to watch, and we believe that wages will begin to rise, which would spur rates on the long end of the yield curve to move up slowly. Even with “lower for longer,” interest rates do have to increase if wages are increasing, and that would push up inflation rates. In fact, the pricing of the S&P 500 energy sector — now at very high multiples — suggests that the market believes that oil prices will move higher later this year.

What to expect when the Fed starts to raise rates
Put together the stimulative effects of cheaper oil, the boost to US consumers from a higher dollar and lower-for-longer rates, and history tells us that economic activity and P/E multiples tend to expand in the initial phases of Fed rate cycles. The equity market also tends to do better in the first 12– 18 months of increases in wages and interest rates.

Historically, that situation has not lasted forever, of course, so we will be on the lookout for a turning point this time. But I think we still have some clear sailing ahead after we get through the rough patch we saw in the first quarter of 2015.

No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.