Peak Earnings

Posted By Darren Winters on Nov 12, 2018


Peak Earnings

The gist of Q3 earnings season is that investor/traders are starting to fret about peak earnings.Despite another quarter of stellar earnings growth, (EPS up 26% Y/Y) investors just aren’t jibbing to the boom in Q3 earnings, instead, they are starting to worry about peak earnings.

S&P500 Q3 earning are back to back jolly but it is lackluster revenue growth which is convincing a growing number of investors/traders that peak earnings could have been reached, or at the very least could be in sight.

Escalating tariffs with China is why investors believe that peak earnings have arrived for the multinational blue chips

Peak EarningsMany of the S&P500 are global companies with global supply chains and export markets. Put simply, trade barriers whether they be in the form of tariffs, sanctions, quotas all have a disruptive impact on global business models which ultimately hits the bottom line of multinationals.

Financial markets are forward-looking so peak earnings are now in the investors’ collective sight

In a piece entitled, “Q2 2018 earnings” I noted that Q2 will not give an accurate assessment of the damage from a trade war, bearing in mind that trade war first shots were fired on Friday (July 6) when US Customs began collecting $34 billion of tariffs of Chinese goods imposed by the Trump administration.

But due to policy time-lag, US companies have yet to report in Q3 any shocks or major adverse impact on profitability from higher tariffs.

Moreover, some corporations might not have reached peak earnings and could be better positioned to survive a US-China trade war.

These are corporations which are able to change to more efficient supply-chains, in other words, more robotics. Their products and services are also price inelastic. So they are able to raise revenue and earnings by raising their prices without dampening demand for their products and services. Indeed, some executives insisted the earnings of their firms would be largely unaffected by the tariffs. For example, eBay (EBAY) suggested that “most of the tariffs have been consumer goods and we haven’t seen very much.” and Rollins (ROL) was “fortunate to be in an industry that is minimally impacted by trade talks or tariffs.” Qorvo (QRVO) also reported that all existing tariffs were “immaterial on [their] business.”

Nevertheless, peak earnings view is supported by even the most insulated corporations sending off distress flares warning that the picture will worsen next year.

Some sectors are already sliding down from their peak earnings

Sea freight sector is first in the line of fire. BDI Baltic Exchange Dry Index is on a steady downward trajectory at 1,470.00 USD. A shipping sector bloodbath could still play out. In 2016, then the world’s seventh-largest container carrier, Hanjin Shipping Co. sought bankruptcy protection.

Overcapacity in the sea freight sector would undoubtedly worsen with an escalating trade war. Tariffs are already slowing timber and grain shipments, raised the cost of clothes hangers and heavy-equipment materials, and compressed margins for chip- and toolmakers, among other effects, WSJ notes. Companies are feeling the tariffs pinch.

The peak earnings view is also being touted by a number of strategists

“The negative impact is pretty widespread across the S&P 500,” said Binky Chadha, chief U.S. equity and global strategist at Deutsche Bank. Still, he said, the overall effect so far is mostly modest.

So peak earnings view is likely to gain traction as the full fall out of a trade-war reaches corporations.

The actual impact of tariffs on 3Q results has been minimal because the implementation of the 10% levy on $200 billion of imports from China only started on Sept 24. Policy time lag and retaliation from the other side is only likely to be reflected in corporate earnings are serval quarters.

So by Q4, we are likely to see this US-inspired trade war with China really start to have an impact on corporations.

The tariff rate is projected to jump to 25% starting in January 2019 and an additional $267 billion of imports may be subjected to a 25% tariff.

There is another less understood reason why peak earnings could have been reached

The cost of borrowing and servicing existing debt is likely to increase. A lot has been written about the Fed’s path to monetary policy normalization. The Fed is keen to normalize the Fed funds rates and unwind its massive 4.2 trillion dollar balance sheet which is all likely to send the 10-Year US Treasury Yield higher and that matters.

Why? When 10-Year US Treasury Yield goes higher that increases the cost of global credit. 10-Year US Treasury Yield is a yardstick for setting the cost of global credit. Mortgages, and credit card debt all become more expensive to service when the 10-Year US Treasury Yield goes higher. Moreover, higher treasury yields trigger a risk-off scenario as investors decide that treasury yields are more attractive than relatively risky dividend stocks.

Treasury yields could also be rising due to the current US administration’s economic policy

The fallout of US-China trade war is that sovereign investors, particularity those whose economies are being damaged by the sanctions and tariffs decide to retaliate by unloading their holding of US treasuries. Russia has already done this and China’s $1.17 trillion holding of treasuries could be next. China’s holdings of the treasury are at a six month low.

What’s more, the bulk of Trump’s trillion dollar infrastructure plan is being financed with US treasuries. So when the supply of anything increases and its demand falls that causes prices to fall, treasuries is no different. This suggests that Trump economic policies, based on simple economics and central bank permitting will cause borrowing costs to spiral along which also supports the peak earnings view.

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