The boost to corporate profits from the tax cuts passed by the Trump administration late last year is obvious. Analysts at FactSet, for instance, estimate that when the first quarter earnings period that began this week is over with, corporate profits will be up about 20% year-on-year.
It is hard to say this is bad.
But according to analysts at Morgan Stanley, the earnings gains from tax cuts resemble empty calories for American businesses, with headline earnings gains showing an inflated view of just how good things are in the corporate world. And investors are catching on.
“We believe that earnings increases from tax cuts are a much lower quality than what we experienced since early 2016 with the re-synchronization of the global economy and that the market will be less willing to pay for this type of earnings expansion,” said Morgan Stanley strategists Michael Wilson and Adam Virgadamo in a note to clients published Tuesday.
The firm added that it thinks investors “will not apply the same multiple to tax-related earnings growth as it does organic earnings growth.” In other words, markets will be less likely to reward companies for big earnings beats relative to expectations if this growth is driven by a one-time adjustment in the corporate tax rate.
Some profit margins are doing better than others
In their note, Wilson and Virgadamo cite the following chart, which shows investors currently focusing on corporate earnings growth before interest and taxes, or EBIT, and not net margins.
Both measures of profitability, in the past, were roughly seen by markets as different but comparable ways to capture a company’s underlying business strength. Following tax cuts, margins are now less useful as they capture a one-time benefit, while EBIT strips this out. Thus, the yellow line and blue lines are diverging.
“The bottom line is that we think the market may still be a bit ahead of itself on earnings growth over the next year and that, in any event, this tax-related growth is lower quality and should not be capitalized in multiples in the same way as the organic growth seen since 2016,” said Wilson and Virgadamo.
“As we move later into the year, we expect the market will begin to contemplate a steep earnings growth deceleration in 2019, not only from lapping the tax-related earnings boost, but also from the building cost pressures.”
Experts begin to cut their stock market forecasts
This view from Morgan Stanley of earnings quality not keeping pace with the impressive headline numbers produced by tax cuts is not dissimilar from commentary out of RBC’s Lori Calvasina last week.
Calvasina last week cut her price target on the S&P 500 for this year to 2,890 from 3,000, citing rising interest rates and higher wages as a barrier for rising EBIT margins — or the earnings before interest and tax that Morgan Stanley cited as reflecting the true underlying strength of corporations.
So while the benefits from tax cuts were certainly a boon to the stock market in 2017, it seems clear investors were to some extent abiding by the old adage of buy the rumor, sell the news. And though the earnings growth expected in 2018 is stellar, the real story is that underlying business performance is not quite as strong as those numbers would have you believe.
Combining this outlook for slowing earnings with expectations for rising wage pressures and higher interest rates, and it almost starts to look like the end of the economic cycle coming into view.
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Myles Udland is a writer at Yahoo Finance. Follow him on Twitter @MylesUdland
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