As Stock Jitters Recede, Focus Shifts to Surging Company Profits

A stream of rosy profit reports has helped soothe the nerves of investors rattled by this month’s stock market plunge. U.S. companies are seeing the

biggest growth spurt
in quarterly earnings in six years, and the pace is set to accelerate.

The question now is whether that momentum will fuel further stock gains.

Tax cuts in the U.S. are padding companies’ bottom lines and funding new investments, but the specter of inflation lingers. Now that most companies have reported 2017 results, it’s becoming clear what could go right or wrong in the coming quarters.

‘Spectacular’ Backdrop

Low unemployment and rising wages are driving U.S. consumer demand, and economic growth is expected to rise to 2.7 percent this year from 2.3 percent. Commodity prices have climbed gradually, spurring activity in mining and oil drilling.

Multinational companies are riding strong growth in Europe and Asia. Global economic strength is fueling sales gains at manufacturers such as

Caterpillar Inc.
, where analysts expect

to rise 12 percent this year.

Banks are well capitalized and ready to lend. And companies are getting a windfall from the cut in U.S. corporate taxes.

“The fundamental backdrop looks nothing short of spectacular,” said Patrick Palfrey, a U.S. equity strategist with Credit Suisse Group AG. “You’re getting economic growth being augmented by tax changes, so you’re seeing the benefits throughout revenue, margins and earnings.”

Global Boom

Similar trends are playing out in Europe, where Siemens AG is riding a booming global economy that’s lifting orders for its factory, transport and energy equipment. Orders for the Munich-based company surged 14 percent in the fiscal first quarter.

In France, Vinci SA, Europe’s biggest builder, is benefiting from the wave of French economic growth. A key measure of contracting sales at its largest division rose 3.6 percent last year, with growth expected to continue in 2018.

Earnings for the most recent quarter at Japan’s Nikkei 225 Stock Average companies beat analyst estimates by 50 percent in aggregate, with 118 reporting positive surprises and 62 negative, according to data compiled by Bloomberg. Overall earnings per share growth was 51 percent, led by a more than doubling of profit at consumer discretionary and telecommunications companies. 

OMG Inflation

But there are some doubts as well, and a big one in the U.S. is quickening inflation. Companies are facing higher costs from labor to transportation to raw materials. Much will depend on the extent they can push those increases through to customers — or at least boost productivity.

“That’s going to be a big challenge for corporate profit margins that are sitting at record highs,” said Jim Paulsen, chief investment strategist with Leuthold Weeden Capital Management.

Illinois Tool Works Inc.
, which makes products from commercial dishwashers to nail guns, was able to match material inflation “dollar for dollar” with price increases in 2017 and expects to do so in 2018. The company expects earnings per share to rise 16 percent this year from 2017.

Food distributor Sysco Corp. posted higher fourth-quarter earnings and is expected to make additional gains this year. But it’s also seeing higher prices on meat, dairy, produce and transportation, and that can’t all be passed through to customers.

“You should probably expect some continued pressure on the gross margin percentage,” said Sysco CEO Tom Bene in a Feb. 5 conference call with analysts.

RATES: Creating lots of interest

Price increases feed inflation and may push the Federal Reserve to raise interest rates more aggressively, damping the U.S.’s eight-year economic expansion.

Higher rates could pressure companies with more debt while depressing consumer demand. For investors, there’s also the risk that if interest rates rise, stocks will face competition from bonds after years of being the only viable investment.

The yield on the 10-year Treasury reached 2.9 percent on Feb. 20, climbing from as low as 1.36 percent in July 2016.

TAX CUT: Show me the money

The reduction in the corporate tax rate from 35 percent to 21 percent will add about 6 percentage points to the S&P 500 Index’s earnings growth, or almost $9 per share, Credit Suisse estimates. What companies do with the extra cash will impact profit.

Many, like

Hilton Worldwide Services Ltd.
and CSX Corp., the largest railroad in the eastern U.S., are returning money to shareholders through higher dividends and stock buybacks.

Emerson Electric Co.
plans to use the tax windfall to increase capacity and improve technology, said CEO Dave Farr in a Feb. 6 conference call.

“If U.S. companies don’t take advantage of what Congress passed in this tax reform, then we’re flaming idiots,” said Farr, who is also chairman of the National Association of Manufacturers.

Stock Valuations

Analysts are predicting earnings will surge about 21 percent more this year. That’s after a 15 percent increase in the last three months of 2017, the biggest since the second quarter of 2011, with gains by companies as diverse as

Facebook Inc.
and ConocoPhillips. Fourth-quarter sales rose 7.9 percent with more than 80 percent of Standard & Poor’s 500 Index companies have reported results.

Even with robust earnings growth, equity valuations are well above normal. The S&P 500 traded at about 22 times current earnings as of Feb. 16, compared with a 10-year average of 17 times. And that’s after shedding about 4.9 percent since a Jan. 26 peak.

“You’ll need to have some pretty robust earnings to power the market forward,” said John Carey, a fund manager for Pioneer Investment Management in Boston. “There’s not a lot of room for error.”

— With assistance by Wendy Soong, Phil Serafino, and Dave McCombs

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