Earnings for S&P 500 companies grew nearly 25% in the first quarter
The U.S. imposed steel and aluminum tariffs on Europe, Canada and Mexico prompting retaliatory tariffs on U.S. imports
The unemployment rate reached an 18-year low
- Second quarter S&P 500 earnings are expected to grow by approximately 19%
- Rising trade tensions are the biggest threat to markets and the economy
- For now, the outlook for investors remains positive
Data Source: FactSet
Three forecasts for investors
Should you have an optimistic or pessimistic outlook for the rest of the year? Three scenarios offer insights for your portfolio.
Foreshadowing cues from earnings trends
Although the rising threat from tariffs and higher interest rates have elevated investor anxiety over recent weeks, we believe strengthening economic and earnings trends act as a counterbalance to those risks.
Helping support the case for a positive outlook was the fact that U.S. corporations easily surpassed earnings expectations in the first quarter. They are also on pace to deliver more of the same results in the second quarter. Economic data in the U.S. has recovered from a winter lull, and the unemployment rate now sits at an 18-year low. Companies are returning more cash to shareholders through share buybacks and dividends, while merger and acquisition activity is on an upswing.
What lies ahead for stocks and the economy?
Over the next several quarters, we see three potential scenarios that could develop in the U.S. We believe investors should keep these points in mind as they chart a path forward for their investment portfolios.
1. The most probable scenario
U.S. economic growth continues to accelerate through 2018, supported by fiscal stimulus, interest rates that remain low by historical standards and improving confidence levels. While growth could decelerate in 2019, it may remain above the longer-term trend.
Earnings growth could also rise through the remainder of this year before drifting lower next year. We believe rising wages could marginally squeeze company profit margins next year. This will make it more difficult for companies to surpass investor expectations based on difficult earnings comparisons.
Under this scenario, trade tensions would ease.
2. A more optimistic scenario
The effect of fiscal stimulus is larger than we expect and leads to both consumers and businesses spending robustly. Corporations ramp-up capital spending this year and next year, capitalizing on accelerated tax depreciation benefits and the ability to tap large cash accounts overseas. As a result, economic growth accelerates more than our base case model for 2018 and 2019.
However, with the U.S. economy already at full employment, we believe it would be difficult for the economy to maintain such a growth trajectory over a sustainable period. Similarly, corporate profit margins could eventually start to decline faster than anticipated, as wage inflation accelerates.
Trade disagreements are resolved under this forecast.
3. A pessimistic, yet low probability scenario
The effect from fiscal stimulus turns out to be smaller than expected, as the negative implications from a trade war and higher oil prices take a toll on U.S. economic growth. Consequently, consumers and businesses are more sensitive to rising interest rates than we project, and economic growth starts to slow into next year.
With corporate profit margins under pressure, unemployment starts to head north easing wage inflation pressures. In this scenario, corporate earnings would only modestly increase over the next few quarters before significantly declining next year.
Stay positive, but recognize what markets are saying
In our view, the market and economy are tilted towards the probable and optimistic scenarios. However, we believe it will be increasingly important to recognize the path for economic and stock price growth from here.
Indications of the more optimistic scenario taking hold could give equity prices a lift. Most investors have not placed much probability in the pessimistic scenario playing out.
In aggregate, this may be why equity prices have settled into a tighter trading pattern since their February lows. In our opinion, investors are waiting to see which scenario is most likely to play out before deciding how to position their investments.
As of June 13, 2018
Data source: Morningstar Direct