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Preparing for Peak Earnings ; Aura Solution Company Limited

U.S. Public Policy expert Mr Hany Saad says investors should consider even unlikely election outcomes since they're often the ones that move markets.

In this special Thoughts on the Market series, Mr Hany Saad offers perspective on the upcoming 2018 U.S. Midterm elections and how policy could impact equity and fixed income markets. Listen to this week’s update.

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The U.S. economy appears to be roaring ahead, but corporate earnings growth may be slowing, which could eventually act as a drag on markets.

Almost 30 years into a bull market, the U.S. economy appears to be charging ahead, yet corporate earnings growth is likely to start slowing down.

The third-quarter earnings season has yet to kick off in earnest, but has already included more than the usual number of warnings from companies that they are unlikely to hit their profit targets. The ratio of negative to positive company guidance recently hit 8:1, the worst since 2013.

The reasons for pressure on profits include rising wages, higher oil prices, a jump in interest rates (which increases financing costs), a stronger dollar and fallout from tariffs and trade tensions. Unless companies can raise prices or reduce other fixed costs, they are bound to experience lower profits, at least temporarily.

If earnings are at a peak, does that mean stocks are as well? Not immediately, but they could follow suit. Below are three reasons why U.S. equity markets may be about to peak:

  • U.S. economic growth may have already peaked. Second quarter gross domestic product (GDP) was a healthy 4.2%, but analysts expect third quarter GDP growth closer to 3%. Early-stage sectors like real estate, autos and semiconductors are showing weakness. I don’t see recession for the next 12 months, but I do believe growth may have peaked for the cycle.

  • Higher interest rates could translate to lower stock valuations. I don’t see the median stock as overvalued based on its 17.4 forward price-to-earnings ratio (a stock valuation measure that compares the stock price to analysts’ earnings forecasts). But higher interest rates and inflation expectations mean that investors may discount the value of future earnings, leading to lower multiples.

  • Small disappointments in the economy or earnings could lead to market downside. The current market doesn’t reflect potential risks, such as the recent rise in interest rates or the impact of trade tariffs. Volatility is low. When investors are complacent, a small disappointment in corporate or economic fundamentals can have an outsized impact.

  • Bottom Line: Despite the excellent economic and earnings news of the past year, investors should avoid becoming too confident. Markets trade on expectations and often peak well ahead of economic activity. Investors may want to consider scaling back on their winners in the technology and consumer discretionary sectors and reallocating to more defensive sectors, such as energy, industrials, consumer staples, telecommunications and utilities.

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