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Corporate profits are sliding in 2019, and Morgan Stanley warns that the Federal Reserve is powerless to halt the trend. “Our earnings recession call is playing out even faster than we expected,” Morgan Stanley says in their latest Weekly Warm Up report. “We are increasingly convinced that consensus earnings expectations for 2019 have further to fall and that the optimistic uptick currently baked into 4Q 2019 estimates is unlikely to happen,” they add. The trend of their projections for 2019 S&P 500 EPS is presented below.
Morgan Stanley’s Slashed Forecasts
2019 S&P 500 Earnings Growth Estimates
- Previous Base Case: +4.3%
- Current Base Case: +1%
- Bear Case: -3.5%
- Consensus Estimate: +5%
Source: Morgan Stanley
Significance For Investors
Morgan Stanley has been ahead of most of Wall Street in predicting deteriorating corporate earnings growth in 2019. Now they see rising odds that earnings actually will decline this year, creating what is called an earnings recession. Accordingly, as presented above, their base case has fallen from 4.3% year-over-year (YOY) EPS growth for the S&P 500 to just a 1% increase. But it may get even worse.
“If current estimates move in line with history, we could see a full year decline of ~3.5% in S&P earnings,” the report warns. Morgan Stanley has kept their year-end 2019 price targets for the index unchanged, since “a lower [interest] rate environment provides support for year end target [valuation] multiples.” These targets are: bull case, 3,000; base case, 2,750; bear case, 2,400. Compared to the Feb. 13, 2019 close, these would represent a gain of 9.0%, no gain, and a 12.8% loss.
However, looser monetary policy from the Federal Reserve will have only a limited effect. “We do not expect the Fed to be the savior with respect to the earnings headwinds laid out…the market has already priced in a lot of Fed dovishness,” the report warns.
The current consensus view is that S&P 500 EPS growth will be negative in 1Q 2019, flat for the first half, and average just 1% for the first three quarters. Then a “hockey stick” rebound creates 9.5% YOY growth in 4Q 2019, bringing the full year increase up to 5%.
By contrast, Morgan Stanley says, “History tells us to expect further downward revisions, higher volatility, and a drag on [stock] prices.” They say that there have been a few dramatic “inflections” in profit growth since the early 2000s, but with backdrops that do not exist in 2019. These big inflections were the result of YOY comparisons to periods of poor profits, or were due to tax cuts.
The 4Q 2019 inflection in the consensus estimate is a hefty 8.5% compared to the average of the first three quarters, a jump from 1% to 9.5% EPS growth. Based on history from 2002 to 2018, Morgan Stanley finds such big inflections in the consensus forecasts often lead to big disappointments. Specifically, when the projected EPS growth inflection four quarters ahead was at least 8.6% higher than the average EPS growth estimate for the prior three quarters, the actual growth rate four quarters ahead fell short of the forecast by 10.4 percentage points, based on median results from that period.
Morgan Stanley has been ahead of the Wall Street pack for several months in anticipating a significant slowdown in earnings growth, and now an outright earnings recession. Given that earnings are the key driver of stock prices, the outlook for continued bull market gains is diminishing.
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