We wind down the 2Q17 earnings season with a smile and a sigh. It was a great season and followed on the heels of a few good quarters. Good earnings can certainly help credit spreads tighten, and the last 18 months have been outstanding for investment grade bond spreads.
S&P 500 companies are looking for sales growth of 5.1% and earnings growth of 9.4% year-over-year in 2Q17, at this time. Most of the gains are attributable to technology, energy and financials, but essentially all sectors are doing well. Across industries, companies with a higher percentage of foreign sales have beaten on the top and bottom line. Gains are broad-based and the trends are unmistakable, as seen in the following chart. So that is the smile part of the equation.
Where does the sigh come in? The factors driving corporate earnings higher could continue for a few more quarters and management guidance is still optimistic. Yet, after all this good news, the next trade could be the anticipation of lower earnings growth in 2018. First, the dollar’s weakness in 2017 (down 9.5% YTD) is certainly a strong tailwind, but we do not believe the dollar’s slide will continue forever.
While Fed speak is relatively dovish, we are still on the path for financial tightening over the next few quarters, as the Fed begins shrinking its balance sheet and continues to raise rates, making continued dollar declines difficult to fathom.
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Second, if wage inflation were to pick up from the anemic levels we have seen in the recovery, corporate profit margins would be pressured. Wage inflation is a lagging indicator, and as we approach cyclical lows in unemployment, wages may finally tick up. Finally, corporate spreads are already at cyclical tights, so more good news may not have much of an impact on spreads.
With good earnings and cyclically tighter spreads, this is a good time to keep some powder dry for better opportunities—which puts a smile on our face.Source: Bloomberg, The Financial Times, BofAML