How Current Earnings Reports Illuminate Tariff Effects
Investors typically examine corporate earnings to gauge business performance, but this earnings season holds particular significance given the trade policy environment. Despite major equity indices achieving record levels amid stabilizing trade relationships, questions remain about tariff impacts on consumers and companies. Encouragingly, fresh trade deals continue to emerge while businesses report results that surpass forecasts.
Recent data indicates consumer expenditure stays robust while corporate profit growth outpaces projections. The Yale Budget Lab reports consumers encounter an average effective tariff rate of 20.2% as of July 23, representing the highest level observed since 1911.1 The absence of this impact in consumer spending metrics suggests businesses may be absorbing tariff expenses rather than immediately transferring costs to customers. Companies seem capable of this approach due to solid earnings expansion and robust profit margins.
More precisely, among the roughly one-third of S&P 500 firms that have disclosed second-quarter results, 80% delivered positive earnings-per-share surprises, while the blended earnings growth rate of 6.4% surpassed projections of 4.9%, per FactSet data.2 Though this growth pace trails recent quarters, it indicates an "earnings recession" – meaning a steep decline in corporate profits like those seen in 2020 or 2022 – appears less probable than initially anticipated.
Corporate earnings are beating expectations so far.
What mechanisms govern tariff payment, and how might these appear in financial data? While tariffs generate government revenue, the actual burden falls on either U.S. exporters or domestic consumers and businesses through elevated prices. The distribution between these groups hinges on their respective "pricing power."
Consider the U.S. dependence on "rare earth metals" for electronics, with nearly all supplies imported. Given limited alternative sources, tariffs would likely transfer directly to consumers. This explains why the administration has pursued agreements expanding rare earth metal imports from China and why domestic production interest has grown.
Conversely, the automotive sector features intense competition among domestic manufacturers and numerous countries seeking U.S. export opportunities. Should tariffs target vehicles from one nation, those producers might absorb portions of the costs to maintain competitiveness against vehicles from other countries and domestic makers.
Therefore, short-term tariff effects depend on industry competitiveness and whether consumers and businesses possess alternatives. Over longer periods, supply chains can adjust to new circumstances and currency values may shift.
Consequently, tariff impacts on earnings and corporate responses differ significantly across industries. General Motors reported tariffs reduced profits by $1.1 billion during the second quarter, with profit margins declining from 9% to 6.1%.3 Conversely, Cleveland-Cliffs, a U.S. flat-rolled steel producer, announced second-quarter earnings exceeding expectations, benefiting from tariffs that curtailed steel imports.4
The above chart demonstrates how earnings expectations vary considerably across sectors, partially reflecting trade impacts. Understanding tariffs' complete effects on companies may require several quarters, particularly as new trade agreements emerge.
Multiple countries have reached new arrangements, some featuring substantially lower tariffs than those initially announced on April 2. Recent announcements indicate the European Union and Japan will encounter 15% tariffs on U.S. exports, while Indonesia and the Philippines face 19% tariffs. Meanwhile, discussions with China continue following earlier progress on a trade truce.
Markets continue to reach new all-time highs.
Financial markets have sustained their climb to record levels as earnings surprises emerge alongside new trade agreements. The above chart shows the S&P 500 achieving over a dozen new peaks this year, with most occurring in recent weeks. The Nasdaq has similarly reached historic levels, surpassing its previous December record, while the Dow approaches new highs. Though current market levels may concern some investors, major indices frequently establish numerous records annually during expansionary periods.
While markets perform strongly, tariff-related economic concerns persist. Various economic projections, including Federal Reserve forecasts, suggest inflation might run slightly higher with somewhat slower growth. Industry-specific impacts will reflect input costs, with import-dependent sectors facing compressed profit margins. However, these projections must consider domestic investment benefits and companies' potential adaptation through innovation and enhanced efficiency.
Although tariffs reach historically elevated levels, predictability matters more, as stable business environments enable companies to adjust operations and supply chains effectively. Looking ahead, current Wall Street consensus projects S&P 500 earnings growing at a 9.5% annual rate. These forecasts anticipate accelerating growth over the coming two years as global trade stabilizes, though significant changes could occur.
Earnings are an important long-term driver of returns.
Equity markets typically track corporate earnings over extended periods. The accompanying chart reveals that while S&P 500 prices and earnings don't align precisely, they follow similar broad patterns. This occurs because economic expansion drives earnings higher, subsequently pushing stock prices upward. Although the economy and stock market aren't identical, they connect closely through company performance.
This relationship demonstrates how tariff effects on profits can influence investors. Whether markets appear "cheap" or "expensive" depends not solely on stock prices but also corporate results. The price-to-earnings ratio simply divides stock or index prices by earnings measures, such as projected twelve-month earnings.
This means even stable prices combined with rising earnings make markets more attractive, and the reverse applies. The current S&P 500 price-to-earnings ratio stands at 22.2x, significantly above the historical 15.8x average and approaching the dot-com bubble peak of 24.5x. Present earnings trends appear positive, but continued market attractiveness will depend on economic growth and earnings performance.
The bottom line? This earnings season may offer valuable insights into tariff effects on consumers and businesses. For investors, comprehending these developments while maintaining focus on long-term planning remains the optimal approach to reaching financial objectives.
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