As the third-quarter earnings season gets under way, we should all expect to be surprised. There is an overwhelming consensus among Wall Street's strategists that their brokers' earnings forecasts, now calling for S&P 500 earnings to rise 4.6 per cent exactly year-on-year, are far too low.
The consensus is overwhelming. JPMorgan expects earnings to "outperform sharply lower expectations". Morgan Stanley's earnings preview is headed "Third-quarter earnings are too low". As the S&P rallied strongly leading in to earnings season, it is evident that many came to the same conclusion. As Bank of America Merrill Lynch put it: "A good third quarter is priced in — guidance better be great".
So, are earnings forecasts too bearish, and if so will there be a further pop upwards for stock markets when this proves to be the case?
According to Thomson Reuters, brokers' 4.6 per cent forecast is down from 5.9 per cent at the beginning of the month, and 14.9 per cent a year earlier. Estimates usually fall as a quarter approaches, but this is a lot. Energy stocks complicate the issue. Thanks to the low base set while oil prices were at their nadir, they are projected to show an annual increase of 139 per cent. Small errors here could have a magnified effect.
Two other reasons why the US earnings outlook has worsened go by the names of Harvey and Irma. The hurricane season ensures that insurers' profits will be worse than expected at the beginning of the summer. How much worse remains a matter of guesswork.
Beyond the specific case of insurers, it is hard to see why US earnings momentum should be as bad as it is, when earnings expectations for the rest of the world remain robust. According to Société Générale, downgrades now make up slightly more than half of all estimate changes for the past four weeks in the US — the same figure for the world as a whole is 51.5 per cent. In Japan, earnings optimism is strong, with 66 per cent of companies upgrading rather than downgrading.
The entire world economy appears to be in a synchronised expansion at present, if a variety of leading indicators are to be believed. That has helped stock markets rally everywhere (including in the US) and it should help the profits of the many multinationals in the S&P. Revenue growth will not be a problem.
Further, those multinationals should benefit, unlike the rest of the planet, from the weakening dollar. This should automatically make their overseas earnings look better in dollar terms. According to BofA this should be the first quarter since 2011 when dollar comparisons actually help US earnings, rather than depressing them.
All of this makes a big earnings beat look like a slam dunk. But now we must consider margins. According to JPMorgan, Wall Street is braced for a reduction of 0.52 percentage points in margins since the second quarter, with only energy and technology expecting an improvement. The bank describes this as "conservative" and forecasts margins could be the kicker for an earnings beat.
This is the critical point of disagreement. To put it in fashionably Marxist terms, capital has been beating labour ever since the crisis. Wage inflation has remained very low, boosting profit margins. With labour markets tightening, and macro surveys showing wage inflation rising to a post-crisis high (from very low levels), there is reason to doubt that this can continue.
Wage growth would be exactly what Trump voters (and anyone concerned by rising inequality) want to see. But it would be doubly bad for Wall Street. It would both eat into margins, but raise the chances of higher rates from the Federal Reserve. That would endanger hopes for future profit growth and multiple expansion.
David Kostin of Goldman Sachs suggests that what executives have to say in their earnings calls about wage pressures and their ability to retain workers will be critical to how this earnings season is received. No issue preoccupies Wall Street more at present — with the possible exception of the prospects for a corporate tax cut, which would transform 2018 earnings prospects if something can be agreed by the end of the year.
Even given concerns about margins, it looks a very good bet that earnings will eclipse forecasts. Savita Subramanian of BofA points out that of the trickle of companies to report so far, 87 per cent have beaten on earnings and 70 per cent on both earnings and sales. This ties with the second quarter as the best showing by early reporting companies since the bank started keeping records in 2012.
The problem is that such beats have already been priced in by the strong markets of recent weeks. She adds: "A solid earnings season may not be enough to move the market higher — valuations are lofty, focus has increasingly shifted to policy, and last quarter, for the first time since the peak of the Tech Bubble, beats were not rewarded".
There is always a temptation, faced by a strong consensus, to bet against it. It should be resisted; it does indeed look as though brokers' analysts have been too conservative. But with the market so strong, and with expectations for future earnings muddied by questions over tax reform, investors should not put more money to work without listening to what politicians say about tax — and what companies say about wages.