Equity markets have been dominated by macro concerns in recent months — including the U.S.-China trade battle and Federal Reserve policy — but the strength of corporate earnings growth in the final third of 2019 and into 2020 will supersede those concerns and deliver positive returns for U.S. equities during the remainder of the year, Mislav Matejka, J.P. Morgan’s chief global equity strategist, told MarketWatch.
“We were looking for a correction in August, but we believe the market will rally into the end of the year,” Matejka said in an interview. “The key call is that the U.S. is not headed for a recession. The consumer is strong, interest rates are coming down and there are signs that global growth will rebound,” he added.
During August, the Dow Jones Industrial Average DJIA, +1.41% fell 1.7%, the S&P 500 SPX, +1.30% declined 1.8% and the Nasdaq Composite Index COMP, +1.75%retreated 2.6%.
Matejka points to data from Refinitiv that shows analysts have already revised down their estimates for year-over-year S&P 500 earnings growth in the second half of the year to 1.6%, below the realized earnings growth of 2.3% in the first half. “Usually what happens this time of the year is expectations are higher, but the expectations for the second half have come down so far that they are below what has happened in the first half.” he said.
Estimates for S&P 500 earnings-per-share growth, derived from analyst targets for individual company performance, typically fall over the course of the year as corporate management seeks to temper expectations for earnings growth in an effort to surpass those forecasts when earnings are announced.
According to David Aurelio, senior manager of equity markets research at Refinitiv, analysts are forecasting a 2% year-over-year decline in earnings-per-share for the S&P 500 in the current quarter, down from a 0.4% decline on July 1, while estimates for the fourth-quarter growth have been reduced from 7.2% to 4.2%.
Given these revisions, Matejka said, “the hurdle rate is low.” For 2020, he expects earnings growth to be between 4% and 6%, below the consensus expectations of 11.1%, but more than enough to keep equity values rising, especially as low interest rates and bond yields drive higher equity-market valuations.
A central argument against Matejka’s bull case is that earnings-per-share estimates have to come down much more than they already have, because corporate profit margins, which are near all-time highs, are due to fall as the cost of tariffs and rising wages continue to harm profits.
“While earnings-per-share growth has not turned negative yet, the [difference] between sales and earnings-per-share growth is meaningfully negative and a massive reversal from what we observed last year,” Mike Wilson, chief U.S. equity strategist at Morgan Stanley, wrote in a Tuesday note to clients. Current forecasts predict that this trend will reverse in 2020, and earnings growth will begin to outpace revenue growth once again, he added.
“The more likely scenario, we believe, is that operating leverage gets worse because sales growth expectations are too high, if consumer tariffs go through and stick and markets remain more volatile, a scenario which is looking more likely,” Wilson added.
Matejka disagreed with this analysis, arguing that wage growth won’t come at the expense of corporate profits, given the recent uptick in productivity growth, a trend he predicts will continue for at least several more quarters, as the economy feels the lagged effects of a 2017 surge in capital expenditures.
“Most commentators think margins are high and therefore are bound to fall, and I am saying that unless there is a recession, there is no real reason for operating margins to contract,” he said.
The major variable that leads to diverging opinions on the stock market and corporate profits is the U.S.-China trade war. While Wilson argues that a resolution to the standoff is appearing less likely, and that tariffs will be a significant drag on S&P 500 revenue going forward, Matejka says the direct effect of tariffs is limited, and while slowing capital-expenditure growth will hurt productivity down the line, that won’t manifest itself until at least 2021.
Even if the announced tariffs set to go into place on Oct. 1 and Dec. 15 go through, Matejka still sees room for the S&P 500 to rise from here. “Everything that has been announced so far has been priced into the market,” he said.
Meanwhile, he discounts the odds of an escalation of tensions, predicting that President Trump will strike the best deal he can as the 2020 election grows closer. Said Matejka, “I would not bet on the escalation because it’s not in his interest to have escalation.”
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