The trade war lull is a good time to assess the damage, and corporate earnings give investors that chance

Taking a look at the world and capital markets through the widest macroscopic lens is a sensible way of determining what matters when it comes to investing. However, now and again the micro-narrative takes over, and the corporate earnings season is one of those times.

The current macroeconomic backdrop is uninspiring but understandable. The trade war has dented corporate activity and economic sentiment, but central banks have signalled their intent to ease rates to steady the economic ship.

The hiatus in the trade war between China and the US and the comfort that central banks are ready to act means investors have a chance to digest the moves in equity markets this year and assess the outlook based on corporate profits. The guidance from companies can shape expectations for future profits and whether there will be any recovery. This matters because while the US might not be experiencing an actual economic recession, it could be going through an earnings recession.

At the time of writing, the US earnings season has only just started and the consensus view of what will be delivered is pretty low. As was the case with the first quarter, the slower global growth, lower oil prices and strong US dollar will all likely add downward pressure to earnings. Then there is the fading effect from the US tax reform package that boosted earnings a year ago.

To a certain extent, the earnings season is a bit of a game. Corporate executives play down the earnings outlook in the lead-up to the release, just enough to soften analyst expectations, which makes it easier to “beat” expectations and to create a bigger earnings surprise. However, heading into the current earnings season, analysts have been revising down their expectations by more than usual, given the added global uncertainty stemming from trade.

So if the market has placed such a low bar for earnings, overcoming that hurdle should be relatively easy, right? The difference will be the divergence in earnings among sectors. The strength of earnings a year ago, thanks to tax reform, was always going to make this quarter tough, but the materials and industrials sectors may find it tougher, given the slowing in capital spending investment.

Any discussion from company executives regarding trade and tariffs will be pertinent to how much it has or will affect business investment in the US. Weakness in earnings usually occurs ahead of a recession and is a clear indication that companies are closing their wallet on spending. This may raise concerns about whether their attitudes towards hiring have changed and the bigger impact on consumption.

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It is not just about headline earnings, though. The trend in margins and revenues is worth monitoring. If sales or revenues are not rising, then it becomes harder to maintain margins in the face of rising costs.

The share of companies beating analyst expectations for revenue or sales has been in decline since the fourth quarter of 2017. In that quarter, 68 per cent of companies reported higher-than-expected revenues; in the first quarter of this year, the figure was 44 per cent. That’s quite a drop.

However, even with most companies failing to beat analyst earnings expectations, US companies are managing to maintain profit margins. Compared to a year ago, margins are starting to be squeezed, but much less than may have been anticipated.

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Wages in the US are increasing at a rate of 3.4 per cent a year and input costs have risen. However, the tightness in the US labour market has not sparked the corresponding surge in wages that history would suggest and we don’t expect this to change in the near term. Neither is it the case that input costs are likely to jump sharply in an environment of low inflation. Finally, given the decline in bond yields so far this year and the expectation of further rate cuts by the US Federal Reserve and the rest of the world’s major central banks, financing costs for companies are hardly a stretch.

Earnings may not deliver any fireworks this quarter, but they will be crucial for assessing just how much damage the trade war has done to corporate sentiment and spending plans. If the guidance offered up is poor, then the chance of a sharp recovery in earnings dwindles, but more cost-conscious companies will work hard to protect margins, which may be enough.

Kerry Craig is a global market strategist at JP Morgan Asset Management