The Devil is in the Details
Despite the dominance of politics in last week’s headlines, companies must still deliver healthy profits to garner the attention of investors. Fortunately, third quarter’s earnings results showed investors just how healthy those profits have been, for the most part, and reaffirmed additional growth on the horizon. Moreover, investors are betting that policy changes promised by the incoming administration will expand that growth potential, at least in some areas of the market. But with the S&P 500 trading at highs rarely seen since the dotcom area (at 22.2 times the next 12 months’ worth of earnings), a bit of caution is warranted. When we weigh the fundamental strength in earnings against possible policy actions, we find the outlook for stocks more nuanced than last week’s market rise might suggest.
Make no mistake, the fundamentals are looking good. With 91% of S&P 500 companies having reported, third quarter earnings growth came in at 5.3% year-over-year, up from its pace of 4.3% expected just before the reporting season commenced. And even though companies guided analysts to expect slightly slower earnings growth than analysts were modeling, companies still expect to deliver over 12% earnings growth for 2024. More importantly, the S&P 500 companies are expected to increase earnings by over 14% in 2025. The recovery from the pandemic’s crushing impact on earnings has been significant and sustained. More sales and more profits have driven stock prices higher. But remember that stocks prices today reflect not only earnings delivered in the past, but even more so, earnings potential in the future.
The future on the policy front creates not only tailwinds for corporate earnings, but also headwinds. Please have a look at Chuck Lieberman’s piece out on Friday for the highlights. When we look at this to judge impacts on earnings fundamentals, we see possible policy changes working through both macroeconomic pathways, but also driving changes for individual industries and companies.
First up is the macro environment. The Federal Reserve’s independence from political pressures remains essential to controlling inflation. Last week, the Fed cut its policy rate by one-quarter point, as widely expected, since inflation is approaching the Fed’s target, allowing attention to shift towards the second part of its dual mandate, maximizing employment. Given that President-Elect Trump has made it clear that he is no fan of Chair Powell’s (when he was president and during the campaign), journalists were eager to know whether Powell would resign before the end of his term in 2026. His answer was a concise “No,” and he also made it clear that he is under no legal obligation to do so. But, as Chuck spelled out, the new administration’s policy plans are more likely to raise inflationary pressures (deficit spending, tariffs, etc.), and so we will likely see far fewer rate cuts in the future than is currently priced in the bond market (and may very well see the Fed’s policy rate rise in the years ahead). The market began to adjust with the US Treasury 10 year up to 4.3%. Powell’s stance and the legal protections for the Fed give investors reassurance that the inflation fight will continue to be well managed by this Fed (a positive for equities generally), but not without (likely) higher interest rates (a negative for some equities). The devil is in the details: investors need to grapple with the impact on individual companies, many of which have adjusted to higher rates over the past few years and already ditched projects whose returns failed to offset those higher borrowing costs.
The promise to deport immigrants and to enact across-the-board tariffs on imports (of 20%) and prohibitive tariffs on China’s (60%) may have devastating macro effects, but only if they come to pass. It seems likely that immigrant labor supply will fall, now and in the future. Less labor will hurt growth and some industries more than others. Many see the tariff threat as a negotiating tactic. Nonetheless, strategic tariffs and those that counter another country’s illegal industrial subsidies may be useful. We may see Trump try to level the playing field. But tariffs always raise costs – to firms that use those imports to build other stuff (or equip their businesses) and to consumers who have long benefitted from cheaper goods from abroad. Higher prices would be a macro headwind, while protection in this form would help some US producers. Here, we are searching the data to identify companies with excess exposure to China, for example.
Fewer regulatory restrictions would help many businesses even as they undermine demand for businesses that serve those regulatory goals – such as those that help to create clean water, air, energy production, etc. Opportunities for M&A are likely to improve and that would help small business and the financial sector, among others, but antitrust attitudes toward big tech are less likely to turn favorable.
Last week’s market move suggests that investors have bet that the good will outweigh the bad in these policies. We see the outcomes as diverse. Fundamentals for companies—sales and profits—stand to be more impacted by policy changes in coming years. We think it has never been more important to dig into the policy impacts at the industry and company level, and see broad-market or index investing facing ever greater challenges.
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