May market outlook: Recovery in corporate earnings

Earnings growth continues, but gap narrows between growth in the U.S. and world.

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Three key takeaways

✔  Corporate profit growth is recovering.

✔  Tighter labor markets and Fed rate hikes could crimp corporate profits.

✔  The gap between profit growth in the U.S. and around the world is tightening.

A recovery in corporate earnings growth continues. Dirk Hofschire, senior vice president of asset allocation research at Fidelity Investments, offers insight on what this may mean for investors in his monthly market catch-up with Lars Schuster, institutional portfolio manager for Strategic Advisers, Inc., a Fidelity Investments company.

Q. What's been going on in the markets most recently?

Hofschire: Here in the U.S., we've been experiencing a recovery in corporate profit growth, and if you remember, this goes back to a downfall in profits that we had in late 2015 that extended through much of last year. Much of that had to do with the global slowdown that we saw, the drop in oil prices, drop in foreign demand, foreign exports falling, and weak global manufacturing. What we’ve had since then, over the last couple quarters, is a rebound from those very low levels. A lot of it is tied back to improving fundamentals in energy companies, industrials, and in many of the areas that are more exposed to the global economy.

I think this type of recovery could last the better part of this year. So it’s after that—maybe looking out to 2018—where the outlook’s going to get a little bit more mixed. We see some positives: There’s hope for business confidence picking up, maybe translating into more capital expenditures, and hopes for, in particular, tax cuts that would help corporate earnings growth very directly. But we also have to remember we're in a more mature phase of the business cycle here in the U.S., and that can sometimes inflate costs for businesses over time.

Tighter labor markets are great for the consumer because of those higher wages, but that starts to crimp corporate profits. As the Fed keeps hiking rates, interest payments to corporations’ debt may go up. All of these things then become more pressure on profit margins and for earnings growth in general. So the outlook right now is very solid here in the U.S., but I do expect as we move forward, we’re going to see somewhat more moderation in earnings growth and its pace in the next 12 to 18 months.

Q. What are the investment implications that investors should consider?

Hofschire: One thing I should add is that when you look outside the United States to international equities, these are stocks that by and large have trailed from a performance standpoint for several years. A big part of the reason is that earnings growth, in many countries around the world, has been much slower than it has been here in the U.S.

But now we're experiencing a really similar rebound in the U.S. to what we’re seeing in overseas markets, and the gap between profit growth in the U.S. and around the world is really close. Then put that together with valuations of stocks in foreign markets generally being less expensive than those in the U.S., along with some currencies that have been beaten down, and this highlights the need to keep a long-term focus on diversifying a stock portfolio, to make sure it's got enough global exposure.

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