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Strength in Earnings and the Economy: Is It Sustainable?

Despite ongoing geopolitical tensions on several fronts, the U.S. economy continues to look strong, and corporate earnings are generally exceeding expectations. Some say much of it is due to a one-time impact from the tax cuts enacted at the beginning of the year; others believe it’s more sustainable. Let’s take a deeper look.

Surging GDP growth

Although gross domestic product (GDP) only offers a backward look at the economy, it’s still a useful comparative statistic. The latest report, released on July 27 by the Department of Commerce’s Bureau of Economic Analysis, revealed that real (inflation-adjusted) GDP jumped to an annual rate of 4.1% for the second quarter.

While the second-quarter estimate was lower than the consensus of 4.4%, it represented the highest pace of growth in nearly four years. Drilling down to the component parts and weights of GDP offers some insights into the sources of that growth.

The largest component of GDP is consumer spending, which represents nearly 70% of the U.S. economy; it rose 4.0% for the second quarter, up from 0.5% for the first quarter. Exports, constituting nearly 14% of GDP, surged 9.3% in the second quarter, primarily due to energy-related exports—but also the acceleration in soybean exports in advance of the retaliatory tariffs put in effect by China. According to Liz Ann Sonders, Schwab’s chief investment strategist, “Given that second quarter import growth was much weaker, at only 0.5%, net exports were on fire.” She anticipates that the pace of growth “will almost assuredly slow in future quarters.”

Business capital spending, accounting for 14.6% of GDP, was up 7.3% in the second quarter, following an increase of 11.5% in the first quarter. According to Liz Ann, this reflects not only the initial benefit from the tax cuts, but also the strength in the energy and technology sectors.

And finally, inventories dropped by about $58 billion to –$28 billion, the lowest level since the last quarter of 2009. The result was a 1.0% reduction to overall GDP.

Productivity accelerates

Based on July’s GDP report and prior revisions, productivity in the second quarter likely accelerated to 1.5% year-over-year, according to Evercore ISI1. Liz Ann points out that “this continued acceleration is probably not getting the attention it deserves.” Calculating unit labor costs as up 1.5% (wage growth of 3.0% minus the 1.5% increase in productivity), she suggests that the result would likely be widening profit margins, which would bode well for earnings and possibly offset some of the negative tariff effects on margins.

Earnings strength continues

So far, second-quarter earnings season is going gangbusters, continuing its trend from the first quarter. Earnings growth within the S&P 500 has been primarily driven by the surge in Energy sector earnings, but also by significant strength from Materials, Financials and Technology. “All told,” says Liz Ann, “earnings are expected to be up more than 24% in the second quarter, following a nearly 27% gain in the first quarter.”

What’s it all mean?

The takeaway from these indicators, along with others, is that economic growth and stock market strength aren’t being driven by just a few companies. Liz Ann comments,“the market is not as narrow as many believe, and the ‘breadth’ within both the stock market and the economy suggest sustainability—although not likely at the current pace.”

The most notable risk to growth, she notes, is trade—an increasingly prominent topic in quarterly corporate earnings conference calls, according to Bespoke Investment Group (BIG). During first-quarter earnings season, less than 20% of companies mentioned tariffs in their calls. But in second-quarter calls through July 30, reflecting about half of all companies reporting, the percentage of conference calls in which tariffs was mentioned had more than doubled. “The net,” Liz Ann says, “is that trade uncertainty remains high and continues to have implications for both the economy overall, and corporate earnings.” In fact, the uncertainty is starting to have an impact on forward-looking economic indicators, including manufacturing and services new orders; this bears close scrutiny over the coming months.

1As of July 27, 2018.

What You Can Do Next

  • Want to talk about Schwab’s outlook on the economy and its potential impact on your portfolio? Call our investment professionals at 800-355-2162.
  • Watch Schwab experts discuss other market and economic topics in the Stock Market Report.
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