We’ve been worried about earnings quality for quite a while now. We’ve said that corporate management teams have been using many levers to drive profits higher, but that top-line growth has generally been very weak. Among the levers companies have been using during this economic recovery have been layoffs, limited wage increases, deferred investments in equipment and technology, debt refinancings (at lower interest rates), debt-funded share repurchases, acquisitions, and restructuring and other expense cuts. Some of these initiatives, like share repurchases and increased leverage, simply represent financial engineering that generates value over a limited term. Other cost-cutting, while positive for earnings and stock prices for a while, will prove to be unsustainable sources of earnings growth. In other words, we’ve said that corporate profit margins cannot continue to rise forever, and revenue growth will have to play a much bigger part in order to drive further earnings increases and justify current valuations.
Fortunately, we are seeing signs of progress. While aggregate S&P 500 revenues suffered significant decreases in 2015 and early 2016, revenue growth turned positive in the second quarter of 2016 and has accelerated in each quarter since. Thus far in the first quarter of 2017, S&P 500 revenue is up about 8.5% year-over-year with about 92% of S&P 500 companies having already reported results. Those of you who follow the markets regularly should know that a recovery in the Energy sector, which saw massive decreases in revenue over a 2-plus year span ending in the third quarter of 2016, has been hugely additive to recent revenue growth for the overall S&P 500. But the Energy sector wasn’t the only sector that suffered from weak revenue growth. Most other sectors went through a weak patch as well. But fortunately, a recovery is at hand – for now.
We decided to see what S&P 500 revenue growth would have been over the past three years if we adjust for the huge revenue volatility in the Energy sector. In the chart below, you’ll see that doing so smooths out the growth rates. In fact, if we assume that Energy-sector revenue grew 3% in each quarter (as we did in the chart below), S&P 500 revenue growth would have been positive in every quarter over the past three years. Perhaps more importantly you will see that, even after adjusting for Energy, S&P 500 revenues have been accelerating quite nicely thanks to broad-based improvement across a number of other sectors.
*Source: FactSet. Orange line assumes Energy-sector revenues grew at a 3% pace in all quarters.
In the chart below, we show further evidence that revenue growth is improving, even without the help of the Energy recovery. The chart shows that S&P 500 revenue growth rates (assuming 3% growth rates each quarter for the Energy sector) are also accelerating on a two-year stacked basis, which simply means the rate of growth over the past two years.
*Source: FactSet. Assumes Energy-sector revenue grew at a 3% pace in all quarters.
As noted above, revenue growth will be needed if Corporate America is to sustain reasonable earnings growth in the future. This is especially true given the reversal of some of the factors that have contributed heavily to earnings growth over the past several years. Specifically, wage increases have accelerated; interest rates are no longer falling; opportunities for cost-cutting are fewer; technology and equipment need to be upgraded after years of deferred investment, and stock prices are much higher (limiting the accretive impact of share repurchases and acquisitions). Furthermore, the increased political noise of late may put at risk the new administration’s plans to stimulate growth through a reduction in tax rates (for businesses and individuals), an infrastructure spending bill, and reduced regulations – all of which would be helpful for corporate earnings.
Our forecast for a persistent 2%ish GDP environment along with 6-7% prospective market returns seems intact. It is clear that many of the market’s tailwinds are becoming headwinds, but sales are beginning to increase and wage increases are supporting the consumer’s ability to recover and spend. Years ago we wrote that the world was looking to China and other emerging markets for growth. We explained that in a post-financial crisis world, with a debt-laden consumer, domestic demand would be sluggish at best. We were correct. The elusive organic demand element that is critical for real, and not financially engineered, growth is showing signs of life. This Lazerean economic renaissance is very welcome yet fragile. The path of US economic recovery is intact but not out of harm’s way. Share prices are stubbornly high, and we of course remain cautious. But, all is not dreary as springtime is showing positive signs.