JP Morgan’s Jamie Dimon is bulled up on the US economy, and JPM’s upside surprise for Q1 earnings on Friday meant investors took his macro overview to heart:
“If you look at the American economy, the consumer is in good shape, balance sheets are in good shape, people are going back into the workforce, companies have plenty of capital… It could go on for years… There’s no law that says it has to stop… There may be a confluence of events that somehow causes a recession, but it may not be 2019, 2020, 2021.”
But as Robert Frost put it, we have many miles to go before we sleep when it comes to Q1 earnings reports. Over the years I have noticed that better-run companies tend to report earlier in the season than their less well-managed peers. That has taught me to be wary of the first flurry of releases in the usual quarterly cycle.
With that caveat in mind, here are the 5 things we think you have top-of-mind as we dive into the heart of Q1 financial reporting season:
#1: Analysts have spent the last 3+ months cutting numbers for Q1.
- At the start of 2019, Wall Street was expecting 2.9% earnings growth in Q1 for the companies of the S&P 500; now expectations call for a 4.3% decline.
- Economists’ expectations for Q1 GDP look much the same, starting 2019 at 2.2% but at just 1.3% now.
- The “Big But”: according to an analysis by FactSet, if companies outperform Q1 expectations by their typical amount (+3.7% 5-year average) then the actual Q1 growth will be essentially flat (-0.3%).
Key takeaway: Q1 will likely be a no-growth quarter, but that’s better than a decline.
#2: Q1 numbers and management guidance will tell us if we will really see an “Earnings Recession” in the first half of 2019, and the important issue to watch is operating/net margins.
- Analysts currently expect Q1 2019 to show net margin contraction, from 11.7% in Q1 2018 to 10.7% today.
- Even if Q1 earnings do end up flat (as the FactSet analysis indicates they may), margin worries will remain since revenues should rise by 5%.
- Q2 2018 expectations currently call for flat earnings (-0.4%) on the back of continued margin pressures (revenues +4%).
Key takeaway: margin pressures are a typical late-cycle problem but last year’s corporate tax cut masked the issue; in 2019 it will be on full display and investors will have to decide what valuations fit with a “peak margin” narrative.
#3: With Q1/Q2 earnings expectations flat, investors will want to hear management confidence that 2H 2019 will still show earnings growth.
- Despite worries over 1H 2019 margins and earnings, analysts are still holding on to hopes that whole-year numbers will show 3.4% bottom line growth.
- This implies a “hockey stick” 2H of 6.8% earnings growth after 2 flat quarters, weighted to Q4 since that is the easiest comp to 2018 (10% earnings growth in the final quarter of 2018 vs. +20% in the first 3 quarters).
Key takeaway: we embrace the old trader’s saying that “markets discount 2 quarters out”, and that means Q1 results/management commentary will have to give hope for a Q3/Q4 earnings and margin bounce.
#4: Since Technology is leading the S&P 500 higher, we need to watch that sector’s earnings reports and margin guidance closely.
- Right now, analysts who follow the Tech sector are looking for a 10.6% decline in Q1 earnings. This is heavily weighted to Apple’s expected 13.6% drop in bottom line results. Microsoft is the other important name to watch, where earnings should be 5.3% higher.
- While not in the S&P’s classification as “Tech”, Amazon (44.3% earnings growth expected), Alphabet/Google (+6.6% expected), and Facebook (-3.6% expected) all bear watching.
Key takeaway: always remember that Tech has net margins that are essentially twice the average S&P company (20.1% vs. 10.7% expected in Q1), and they are notoriously hard to predict. Year-to-date price action says there is upside to expectations, but the margin sword cuts both ways.
#5: What will rising confidence on US corporate earnings (as we saw Friday) do to expectations for future Fed Funds rates?
- The odds of a Fed rate cut in 2019 are down to 39% from 51% a week ago.
- Yields on 2-year Treasuries (the maturity most tied to future Fed policy) troughed for the year-to-date on March 27th at 2.21%. They now stand at 2.39% and seem to be grinding higher.
Key takeaway: let’s assume Jamie Dimon has a better look at the US economy than anyone else, including the Fed, and his bank’s Q1 performance is a reasonable proxy for the US financial system. Combine his comments with JPM’s numbers and you do not get much of a recipe for a rate cut in 2019.
Summing up: Friday’s rally signals that US equity traders think Q1 estimates are too low, buoying confidence in more upside surprises over the days to come. Our point today is that managements will have to sign up to a Dimon-esque level of bullishness to make that narrative hold because the real worry is margins and interest rates, not just reported EPS.