Tariffs May Only Have A Minor Impact On The S&P 500 Earnings

Tariffs May Only Have A Minor Impact On The S&P 500

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The market keeps swinging widely on rising and falling trade tensions. So just how much will the trade war hurt the S&P 500 earnings estimates? So far, it seems like that is an open-ended question that nobody has the answer too. Really how could they? It is hard to gain insight into how companies may be changing operations or not until they provide guidance and updates. The latest operating earnings estimates from S&P Dow Jones are out, and as of May 23, they are forecasting earnings of $165.50 in 2019, down from $165.53 last week. Additionally, the estimates for 2020 have increased to $185.30 from estimates last week of $185.29, unchanged. At this point, the estimates seem to be unaffected, but it may take several weeks before estimate start to reflect the tariffs.

It leaves the S&P 500 trading at 15.25 times 2020 earnings estimates, which is still well below the historical averages.

The Model

I created a ratio that uses the US GDP and operating earnings. I came away with a few exciting surprises. First off, I found the results to be incredibly consistent; I was expecting something that would be more scattered and random.

The chart below shows that since 2001, operating income has been growing as a percentage of the GDP. We can see that currently operating income represents almost 7% of the US GDP, and above the high in the 2014/15 cycle. It makes sense to some degree given the tax reform bill.

The Impact

I then used current earnings estimates through the year 2020 to find future operating income, and I estimated the future GDP growth at an annualized rate of 2.5%, using the current earnings estimates of $185.30. What I found was that operating earnings are estimated to continue to rise in the future, and are forecast to represent nearly 8% of the US GDP. It makes sense considering earnings are expected to grow at almost triple the pace of GDP over the next two years.

I then lowered the GDP growth rate to 2.2% per year, which is 3/10 of a percent lower and what many estimate the impact to GDP growth will be from the tariffs. I came to an earnings per share of $184.34, about 50 bps less than current estimates. If I decreased that growth rate further, to 1.5%, earnings estimates slumped to $182.10 per share, about 1.7% less.

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Assuming earnings as a percent of GDP remain consistent, an overall minor slow down in the economy will not have a significant impact on earnings estimates. However, the model has a flaw because if the percentage of operating earnings to GDP falls, it could have a substantial effect on overall profits. For example, should earnings drop to represent 6% of total GDP, the earnings per share could drop by 23% from current estimates to $142.25 from $185.03.

When we think about the tariffs and their potential impact, on the surface, a slowdown in the economy itself is likely not to drive the market down or earnings. The significant risk is how much a slowing in earnings growth will be and how much they fall versus the total US GDP that may matter most.

At this point, it would seem the impact of the tariffs is not fully reflected in earnings estimates. So we will need to continue to wait and see what happens next. But as long as earnings as a percentage of overall GDP remains consistent at current levels or higher, the impact is likely to minimal.


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