Summary: In the long run, earnings are all that matter for markets. As we head into Q3 earnings season, attention should be focused on margins, given cooling inflation (a negative for sales growth) and cooling cost inflation (a positive for margins). More importantly, global earnings estimates have been cooling recently, an unsustainable trend given that most index prices keep rising. Corporate hints at the future will drive the next move in earnings revisions; listen closely.
Over time, equity markets go up because earnings go up, and earnings go up because the economy expands. Sure, the market moves up and down more than earnings as the market multiple (PE ratio or valuations) fluctuates given investor mindset, risk, outside factors, interest rates, etc. And the economic relationship to earnings is loose, too, as operating and financial leverage influence the equation. Yet all these other ‘noise’ factors tend to revert over multi-year time periods, leaving a rather direct relationship between markets and earnings. So clearly, today’s earnings matter as we head into Q3 earnings season and tomorrow’s earnings.
Is the S&P expensive at 21.8x estimated earnings for the next 12 months? And is Canada cheap at 15.3x? It is not just what you pay for current earnings but how they will grow over time. The S&P has been more expensive for years and has outperformed, mainly because it has enjoyed strong earnings growth. In 2024, US headline earnings were just under 10%; this rises next year. Canada has pretty low growth in 2024, with some better growth next year. Europe and Asia are cheaper than the US and a bit cheaper than Canada, with less earnings growth over the coming years. All these projections sort of make sense.
Markets tend to move on to new information, so this coming earnings season and future seasons contain a ton of information from companies on how their businesses are running. The big question will be whether the US will be able to attain that lofty 14% earnings growth into 2025… or exceed it.
While the overall economy may drive earnings growth, manufacturing economic activity does have an outsized weighting for S&P 500 earnings. This may pose a problem. A strong relationship exists between the monthly survey of manufacturing activity (PMI) and earnings growth six months into the future, showing a 0.7 correlation. During the past couple of months, we have seen a drop in the PMI manufacturing survey, which may imply a softening of the pace of earnings growth. Directionally, this is a pretty strong relationship, so it may be a challenge for the S&P to post increasing earnings growth into 2025, as current consensus estimates would imply with manufacturing activity slowing.
On an equally sobering note, previous months' positive earnings revision trend appears to have reversed, even for the mighty US equity market. The optimism for 2025 earnings across the board appears to be cooling.
There are some good news factors as well. Even though inflation is cooling, measured via CPI, producer prices are cooling faster. That may help keep profit margins at healthy levels. Plus, wage pressures appear to be softening as well. Good news on the cost side for many corporations. Perhaps the biggest piece of good news is falling overnight rates as central banks gradually move back to whatever normal rates will be. This helps keep some upward pressure on the market multiple, or what the market will pay for a $1 of earnings.
Final Thoughts
It is challenging to bet against corporations. They are very good at managing expectations, rising costs, and delivering. However, much of the market's rise over the past few years has been based on whichever market was enjoying the best earnings growth. Given that current estimates for 2025 favour the US market for growth over others, perhaps US exceptionalism will continue. Still, the US is priced for near perfection, which raises the risk that reality falls short of estimates.
This earnings season will be critical to determining whether companies are still largely able to manage variations in inflation, costs, wages, interest rates, and other moving parts.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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Sources: Charts are sourced to Bloomberg L. P.
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