As you can see from the following chart, U.S. corporate earnings for the S&P 500 took a tumble from late-2014 to Q1 2016. Many investors at the time were predicting that the earnings recession would result in an economic recession. We disagreed. We stated that the entire decline in earnings was due to falling energy earnings (oil prices crashed). The rest of corporate America was experiencing decent earnings growth. The energy sector is not the most important part of Corporate America.
It turns out we were right. Here’s why earnings growth has been solid over the past few quarters, and why earnings growth will continue to be decent in the next few quarters.
Why Q1 2017 was a good earnings season.
Most of the results for Q1 2017 earnings season have been released. Most of the major Dow companies, financial companies, and tech companies have released their earnings reports.
On December 31, 2016, analysts predicted that the S&P 500 companies would experience 12-13% year-over-year earnings growth in Q1 2017. By March 31 2017, they had downgraded that expectation to 9% growth. With most companies having released their reports already, it seems that the year-over-year growth rate will come in at 12.5%, which is inline with initial expectations.
This is the highest year-over-year growth rate since 2009. 2 sectors are driving this:
- Finance stocks
- Energy stocks
These 2 sectors account for the bulk of the increase in earnings growth.
Financial stocks are doing well because interest rates are going up. With the Fed keeping rates on hold until late-2015, banks’ profits margins were squeezed. But now that the Fed is hiking rates and interest rates are rising on their own, the profit margins for banks is expanding.
E.g. It’s hard to make money when a bank is borrowing at 1% and lending at 1.15%. It’s easier to make money when the bank is borrowing at 2% and lending at 2.4%.
Keep in mind that earnings is reported as year-over-year growth. 10 year Treasury yields were at 1.8% at the end of Q1 2016, while 10 year yields stood at 2.4% at the end of Q1 2017. That year-over-year surge in interest rates caused banks’ profits to rise. The 10 year yield stood at 1.5% at the end of Q2 2017. So as long as interest rates remain above 2% in the next few months, banks’ should continue to see a surge in profits over the next few quarters.
Earnings for energy stocks strongly follows the price of crude oil and natural gas.
Keep in mind that earnings is reported as year-over-year growth. Energy companies are making more profits because oil prices have been rising year-over-year. WTI crude oil stood at $37 a barrel at the end of Q1 2016. It stands at $50 at the end of Q1 2017. The 38% increase in crude oil prices caused energy profits to surge.
Oil prices rose during Q2 2016, ending at $49. Oil is hovering around $50 right now. So unless oil prices surge this quarter, Q2 2017’s year-over-year growth in energy earnings will decrease.
The following is crude oil’s chart over the past year.
What this portends for future earnings
Earnings over the next few quarters will continue to grow. Growth in the energy sector will slow down a little while growth in the financial sector will continue to be strong. Overall, earnings growth will be strong, but probably not as strong as Q1 2017.
Some investors have asked “why are corporate earnings growing at double digits while the U.S. economy is growing at low single digits”? The answer is simple. U.S. companies are experiencing rapid growth in overseas earnings.
Since early-2016, European and emerging market economies (mainly China) have rapidly recovered. That is why U.S. multi-national companies achieved almost 20% year-over-year earnings growth. Their strong earnings growth is dragging up the entire S&P 500’s earnings growth.
For example, construction companies like Caterpillar are experiencing very strong growth in their Chinese units.