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US Corporate earnings to bottom out in 2009 May 15, 2009
2009 continues to be a difficult year for the US economy but it is also an inflection point for economic growth and corporate earnings. We examine the latest economic growth data and consensus earnings estimates for a better idea of valuations.
Author : Terence Lin


Untitled Document
Chart 1
Chart 2
Chart 3
Chart 4
Chart 5

At its closing low on 9 March 2009, the US market (represented by the S&P 500) had declined by 56.8% since peaking in October 2007, marking one of the worst bear markets since World War II. Since then, the S&P 500 has gained 34.1% (as of 7 May 2009, in USD terms), a strong performance over just 2 months. Is the bull finally and truly born again? This is the question at the tongue tips of many investors, with recent market rallies reminiscent of those seen in the previous bull markets. In this update on the US, we examine the recent advance GDP release for a better picture of conditions in the economy. Also, we look at the estimated earnings of the S&P 500 to obtain a better idea of US market valuations.

Table 1: GDP Components
(Actual, Annualised quarter-on-quarter change)

2008-2Q

2008-3Q

2008-4Q

2009-1Q (*)

Gross domestic product 2.8% -0.5% -6.3% -6.1%
Personal consumption expenditures 1.2% -3.8% -4.3% 2.2%
Gross private domestic investment

-11.5%

0.4% -23% -51.8%
Exports

12.3% 3.0%

-23.6% -30%

Imports

-7.3%

-3.5% -17.5% -34.1%

Government consumption expenditures and gross investment

3.9% 5.8%

1.3% -3.9%
Source: US Bureau of Economic Analysis, * denotes advance estimates.

INVENTORY DRAWDOWN DRAGS ON GDP, BUT CONSUMPTION HOLDS UP

Advance GDP estimates for the US economy showed a 6.1% quarter-on-quarter annualised decline for the 1st quarter of 2009, worse than the consensus estimates of a 4.7% decline (see Table 1). This was a poor performance for the US economy, coming after the 6.3% decline in the 4th quarter of 2008. However, a closer look at the finer details of the GDP report reveals several items which are of more interest than the overall growth numbers.

In the first quarter of 2009, gross private domestic investment declined a stunning 51.8% from the previous quarter on an annualised basis, resulting in a -8.83% contribution to GDP growth (see chart 1). This was led by a sharp drop in business investment and a large decline in inventory levels. In 2000 dollars, private inventories declined by US$103.7 billion, compared to a US$25.8 billion drop in 4Q 2008, contributing -2.79% to the decline in GDP.

Table 2

Spending on Gasoline, fuel oil, and other energy goods

2008-4Q

2009-1Q

q-o-q

in Billions of current dollars (USD) 318.1 268.1 -15.7%
in Billions of chained (2000) dollars (USD) 187.9 190.9 1.6%
Source: US Bureau of Economic Analysis.

Surprisingly, personal consumption expenditures (PCE) gained 2.2% quarter-on-quarter on an annualised basis, leading to a positive contribution of 1.5% to GDP growth. We previously suggested that consumption will be pressured in 2009, with rising unemployment and a declining wealth effect due to collapsing asset prices (see US economic growth may return in 3Q 2009) and 1st quarter advance estimates have certainly surprised on the upside. A look at the PCE reveals that spending on “gasoline, fuel oil, and other energy goods” declined by US$50 billion (in current dollar amounts) in 1Q 2009 due to the lowered gasoline prices. This was a 15.7% quarter-on-quarter decline, but was reflected as a 1.6% gain in real terms (see table 2). Thus, by spending less on gasoline, the US consumer had more to spend in other areas, thereby boosting PCE in 1Q 2009. Tax cuts also contributed to a 5% quarter-on-quarter annualised gain in disposable income, which had a positive impact on consumer spending.

Worst quarter likely behind us, inventory and investment to pull up growth

The US personal savings rate has now increased to 4.2% (as of end March 2009, see Chart 2), significantly higher than the 1.6% average since 2000. With crude oil prices having risen 40.9% from lows in February (as of 8 May 2009), gasoline prices are likely to track this rise (gasoline prices typically lag crude oil price movements) which could impact other forms of discretionary spending in the current quarter. Tax rebates will continue to boost spending, but this has already had an impact in the first quarter and we are expecting consumption to weaken slightly from 1Q 2009 levels.

However, we should see investment rebound in the current quarter (2Q 09), helped by better credit conditions, greater stability in the housing market, and also the extremely low base set in the first quarter. For this reason, we believe that the 2nd quarter will show a less severe decline, and positive growth may return as early as in 3Q 2009. Private inventory levels have the potential to make a huge impact on growth numbers in the current quarter: a decline in inventories of less than US$103.7 billion (in 2000 dollars, and largest historical quarterly decline) would contribute positively to GDP, and inventory declines should be arrested either in the current quarter or by the 3rd quarter latest.

Focusing on Corporate Earnings

We believe that the worst of the current downturn has already been reflected in 4Q 2008 and 1Q 2009 GDP numbers, and that economic growth figures will increase going into the next few quarters. Our attention now turns to corporate earnings, which we believe are an important factor in determining the sustainability of a market recovery. Corporate earnings tend to recover after the worst quarter of GDP growth (on a quarter-on-quarter annualised basis, see Chart 3), which suggests that the worst of corporate earnings should be seen in 2009.

Since the subprime crisis erupted in the US, estimated earnings for the US stock market have been on a downward trend (see chart 4). As of 8 May 2009, the consensus now expects earnings of about US$510 billion for S&P 500 companies in 2009 which translates to an earnings-per-share (EPS) of $57 for the S&P 500, approximately 47% lower than estimates made in mid-2007. Prior estimates were made when “subprime” was dismissed as a minor blip which would pose little threat to the US economy, much less to the rest of the world. Economic conditions have deteriorated significantly since then, resulting in a huge downgrade of expectations for US corporations.

The good news – 2009 likely to be worst year for US corporate earnings

With the worst quarter of growth likely behind us, earnings are also expected to bottom out in 2009. Expectations of earnings have been rapidly slashed from August 2008, but downward revisions have already eased off in 2009, with the month-on-month changes looking less severe. Table 3 reveals more details about current earnings expectations for the US market: Earnings of the energy and materials sectors are expected to be the hardest hit this year as prices for commodities and energy products have declined from 2008 levels. Earnings for financials in 2009 are coming off an extremely low base (recall that AIG lost US$99.3 billion in 2008 alone) and these financial companies are thus expected to post strong year-on-year earnings growth in 2009.

Table 3:

 

Consensus Expected Earnings Growth

 

2009

2010

2011

S&P 500 -16.0% 24.2% 22.1%
Consumer Discretionary -31.0% 82.3% 32.2%
Consumer Staples 1.6% 7.0% 10.4%
Energy -60.1% 43.6% 40.2%
Financials 777.7% 65.4% 51.8%
Health Care 0.2% 10.2% 9.5%
Industrials -32.5% 6.5% 16.0%
Information Technology -16.0% 16.5% 15.2%
Materials -61.7% 81.7% 29.1%
Telecommunication Services -19.8% 6.8% 7.1%
Utilities -2.0% 8.8% 7.6%
Source: Bloomberg, as at 8 May 2009

The bad news – Forward earnings revisions are a key risk

The key risk here is that current estimated operating earnings for 2010 and 2011 are too optimistic. The consensus is predicting a “V” shaped recovery in corporate earnings for US companies over 2010 and 2011 (see Chart 5), which may not materialise. Fluctuations in energy and commodity prices will affect the earnings of the energy and materials sectors, which mean that the expected improvements in earnings in the forward 2 years are at risk. Also, the financial sector is expected to return to meaningful profitability in 2011, with expected earnings for the sector in that year only 18.6% less than what the sector earned in 2007. Issues like increased regulation and lower levels of leverage may weigh down on future profitability, which could result in downside risks to forward earning estimates.

Taking forward earnings with a pinch of salt

If earnings expectations for 2009 come to fruition (and we expect so), the S&P 500 currently trades at a PE ratio of 16.3X for 2009 (as of 8 May 2009). This is not an attractive level compared to the historical average of 16.4X (calculated on a historical PE basis, using data since 1954).

However, based on current expectations of earnings in 2010 and 2011, the forward PE ratios for the US market are only 13.1X and 10.8X respectively, indicating much more attractive forward valuations. With 2009 earnings having been revised downwards by almost 50% in the span of a year (recall Chart 4), investors would do well to take current earnings estimates with a pinch of salt, in the knowledge that changes in macroeconomic conditions and countless other factors may have a significant impact on these estimates. Estimates are traditionally more accurate when the trend is well-established (both in economic expansions or contractions), but we have hit an inflection point for earnings in 2009, which means that forward expectations are less dependable. We thus do not rule out revisions (whether upward or downward) to these forward earnings, and also acknowledge that attempting to accurately forecast earnings 1-2 years down the road given the uncertainty in economic conditions may be an exercise in futility.

That being said, we believe US GDP and corporate earnings will both bottom out this year, and the worst-case scenario would be for earnings to be maintained at current low levels over the next 2 years and not decline further. In such an adverse scenario (which is highly unlikely to occur), the current level of the S&P 500 would indicate a fairly valued US market, with valuations at the long-term average.

With this adverse scenario not likely to occur, we prefer to discount consensus 2010 and 2011 earnings growth by 30%, giving us 16.9% growth in 2010 and a further 15.5% in 2011. This gives us PE ratios of 13.6X and 11.8X for the two respective years (as of 11 May 2009), which are below the long-term average PE of 16.4X. At such valuations, we believe that the US market still remains attractively valued.

Moderately attractive at current level.

Since our last update on 17 February 2009, the S&P 500 has returned 15.2% (in USD terms, as of 11 May 2009). Despite the strong performance, valuations on a price-earnings basis suggest that further upside is likely for the US market. On one hand, economic growth is likely to turn positive in 3Q 2009 which will may continue to fuel the current rally (remember that stock markets are forward-looking) and earnings are likely to bottom out this year. However, downside risks to forward earnings and a weaker US dollar are lingering issues. In light of the moderately attractive valuations, we will be reviewing our 4-star rating on the US market and will provide an update in conjunction with the other regional markets in our quarterly star rating update in June.

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