The Independent Market Observer

Earnings Recession Ahead? Not So Fast

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Feb 13, 2019 2:57:02 PM

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earnings recessionWe talked yesterday about the possibility of another government shutdown and the effect that could have on both business and consumer confidence. That shutdown looks to be something we will avoid. But now there is another potential confidence buster ahead being talked up in the media: an earnings recession.

Earnings recession defined

An earnings recession is when corporate earnings decline for two quarters in a row. The term is taken from an economic recession, when the economy declines for two quarters in a row. In both cases, a one-off is assumed to be something that happens occasionally. But two quarters in a row is considered a trend. Right now, some analysts are looking for earnings in the first quarter of 2019 to be down on the prior year, with a rising risk that second-quarter earnings will be down as well—leading to that earnings recession.

Take a step back

Before we get too wound up, however, let’s take a step back. First, we don’t know what earnings will be for the first quarter. We are only halfway through it, and analyst estimates can vary widely over time. Second, we certainly don’t know what to expect for the second quarter. Since we simply don’t have the data—and we know analyst estimates usually bounce around significantly anyway—it is premature to worry about it too much. Although analysts are marking down their expectations, that is typical at this point in the cycle. In fact, those same analysts usually adjust expectations up even as companies outperform.

For the fourth quarter of last year (as of last Friday), we had 66 percent of the companies in the S&P 500 reporting. Almost two-thirds (62 percent) had higher sales than analysts expected, by 1.2 percent, and almost three-quarters (71 percent) had higher earnings growth, of 4 percent (according to FactSet). Revenue surprises are higher than has been typical over the past five years, while earnings surprises are somewhat lower. Expected revenue growth for the quarter as a whole is 7 percent; for earnings, it is 13.3 percent, which is well away from a decline. These numbers show corporate America has a lot of momentum behind it, and any earnings decline would represent a significant slowdown.

What does the data say?

We don’t see that kind of slowdown in the economic data. Consumer spending growth is still healthy. Confidence is down, but it remains at healthy levels as well. U.S. demand looks solid. Similarly, while international sales growth is down, which has been the case in the fourth quarter, it still allows for healthy growth. Despite the real slowdown and the risks, companies are making more money. An earnings recession would require that to have changed by now, and we simply don’t see that yet.

What if everything goes wrong?

Much of the pessimism looks to derive from recent events, including the ongoing trade war, the government shutdown, and slowdowns in Europe and China. If all of these persist, it could indeed bring about the collapse in demand that would result in a first-half earnings recession. Right now, though, we see progress on trade, a reduced likelihood of another shutdown, and continued Chinese economic stimulus. An earnings recession in the short term requires everything to go wrong. But just as everything almost never goes right, it makes no sense to bet on everything going wrong either.

We are certainly seeing the potential start of a slowdown. At some point, that will result in both an economic recession and an earnings one. With economic momentum still healthy, just as the economy is still showing a green light, I expect corporate earnings to keep growing over the next quarters as well. And if everything goes wrong? We will have enough time to see that coming and react.

Keep calm and carry on.

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