Rising yields could be a big problem for booming corporate profits

Key Points
  • S&P 500 companies are expected to report profits of close to 20 percent for the third quarter.
  • Investors will be watching earnings calls to hear how companies are going to handle three pressures: rising yields, increasing wage pressures and tariffs.
  • Though stocks generally rise along with rates, the sudden burst higher for government bond yields is actually consistent with falling equity prices.
Pedestrians walk on Wall Street near the New York Stock Exchange in New York.
Michael Nagle | Bloomberg | Getty Images

When third-quarter earnings season starts in earnest later this week, companies by and large will report that the present is all bright and rosy. The future? That could be another story.

Corporate America faces a variety of pressures, but three right now are especially daunting: Rising rates, tariffs and increasing wages. Those issues, according to Goldman Sachs strategists, will be paramount for company officials to address on earnings calls.

"The 3Q earnings season that begins next week will continue the pattern of stellar results that companies reported during 1Q and 2Q 2018," David Kostin, Goldman's chief U.S. equity strategist, said in a note.

"Recent economic data releases have been extremely strong but the current positive fundamental news also introduces risks for 2019," he added.

earnings are projected to rise at least 19.2 percent, according to FactSet. While projections are trending lower, that level would still be third-best since the first quarter of 2011, behind the first two quarters of 2018 when profit growth was around 25 percent.

These sectors are poised to do well amid a backdrop of rising rates: Strategist

The big story for investors lately, though, has been the surge in bond yields, pushing the benchmark U.S. 10-year Treasury note yield to about 3.23 percent, its highest level in seven years. As things currently stand, not only is the 10-year above the S&P 500's 1.81 percent dividend yield but so is the three-month note, which is currently yielding 2.22 percent and offering investors a viable risk-free alternative to a suddenly volatile stock market.

Broadly speaking, stocks in the past have done well in rising rate environments.

However, Kostin pointed out that the sudden spike in the 10-year — 33 basis points over the past month — equates to two standard deviations and is typically associated with negative returns. Goldman has found that stocks typically grow with moves of less than 1 standard deviation per month, are flat with between 1 and 2 standard deviation moves, and fall with anything above 2.

The pressure from yields comes as the economy continues to catch fire. Friday's nonfarm payrolls report showed unemployment at a 49-year low, a nonmanufacturing sector reading last week showed activity at its highest level since the survey began in 1997, and the National Federation of Independent Business' small-business sentiment gauge is at its highest level since it started 44 years ago.

Thus far, the acceleration in economic activity has most of Wall Street believing that the rise in yields won't last or at least won't halt the positive momentum. Stocks have been on a modest losing streak lately but still are around where they were a month ago when the surge in yields began.

But even some bulls are getting nervous.

"When it comes to interest rates, it appears speed defines everything and last week's 17 [basis point] jump in 10-year yields served as another reminder that speed can kill equity market rallies. We were also reminded of this in February after yields rose at nearly the same pace," Craig Johnson, chief market technician at Piper Jaffray, one of Wall Street's most consistently optimistic firms, said in a note. "However, at the risk of using 'this time it's different,' the technical backdrop for rates appears much different when comparing the recent rise in yields to January."

Yields will be a challenge to the stock market this quarter: Siegel

January is an important comparison. The payrolls report from that month showed a steep gain in average hourly earnings, stoking inflation fears and a stock market correction.

However, the 10-year never decisively cleared 3 percent, as it has done now, and Johnson sees that as important.

"We remain cautious on the near-outlook for U.S. equities as cracks continue to emerge within our technical research," he said. "Breadth, momentum, and leadership are all deteriorating while yields recently witnessed major breakouts to multi-year highs."

Like Goldman, Piper has a 2,850 year-end price target on the S&P 500, implying a roughly 1 percent decline from current levels.

The trade war and rising wages

While rates take center stage, tariffs and wage pressures also will be important. Investors likely will be listening closely during earnings calls for what role both are playing in company outlooks.

Kostin said the U.S. tariffs levied against $200 billion worth of Chinese goods happened too late in the quarter to have much impact. What will matter is what happens from here.

In the worst-case extreme scenario, the tariffs and resulting price increases could wipe out all of the projected fourth-quarter profits. However, that assumes no use of other suppliers, no pass-on to consumers and no rise in domestic revenues or boost from economic activity. Impacts instead will be felt by industry.

"Affected firms will likely address concerns on their earnings calls. In fact, some firms have already discussed the potential impacts," Kostin said. "Firms with high and stable gross margins are best positioned to withstand input cost inflation regardless of the cause."

Similarly, companies with the strongest balance sheets and lowest debt loads will be affected least by rising rates, while companies that have less exposure to rising labor costs will do best amid the higher wage pressures, he added. While the Labor Department reported Friday that average hourly earnings rose 2.8 percent year over year, Goldman's own wage tracker sees a 3.3 percent increase, which is the highest since the recovery began in 2009.

Wage pressures are a sign that inflation is building in the system. The Federal Reserve has responded by gradually increasing its benchmark rate, and Chairman Jerome Powell strongly indicated last week that the Fed remains a good distance from what it would consider a "neutral" rate that would generate a pause in the current cycle.

So far, the effects from inflation remain fairly muted. But corporate officials will be looked at for indications of whether that will remain the case.

"Labor costs are significantly below where they were in the previous tightening cycle, leading us to believe that inflationary pressures have an ample cushion before they reach alarming levels," said John Lynch, chief investment strategist at LPL Research. "Nevertheless, markets may be sensitive to signs of growing inflation, especially with longer-term yields and stocks near multi-year highs."