Market focuses on revenue growth as the key to combating rising costs, interest rates

Fear of higher costs, through higher interest rates, higher wages and higher raw material costs, has now become a major preoccupation for investors. But strong revenue growth, if it continues, may offset concerns that higher costs will erode profit margins.

We’re just getting started with earnings season, but the early signs are looking even better than the bulls were anticipating.

Tuesday’s big movers, including Goldman Sachs, Morgan Stanley, Comerica, UnitedHealth and Johnson & Johnson, all beat by wide margins. All these stocks are trading up.

With just 41 companies in the S&P 500 reporting so far (8 percent), 88 percent have beat on earnings, far above the roughly 65 percent that typically beat, with earnings growth of 25.4 percent, according to Earnings Scout. That would uphold a string of 20 percent or greater earnings growth that began in the first quarter and is expected to extend through the end of the year.

But the key to the market’s upward momentum may be in a related statistic: Revenue growth. It is what is needed to offset the potentially higher costs corporate America now faces.

Chief among those higher costs are higher interest rates, which will drive up funding costs. Last week’s market action clearly telegraphed that traders and fund managers are worried about a sudden spurt up in interest rates. Indeed, Bank of America/Merrill Lynch’s monthly report on fund managers’ biggest fears shows concern about the Fed tightening faster than expected is moving up on the list of the biggest fears. It is now almost tied with a trade war as the biggest threat to the market.

Trade war: 35 percent

Fed/Quant. tightening: 31 percent

China slowdown: 16 percent

Source: Bank of America Merrill Lynch

Higher costs without higher revenue can lead to margin erosion, and that can be a rally-killer.

Corporate revenue has steadily improved as the economy has strengthened. Revenue growth historically has averaged in the 3 percent to 5 percent a year range, according to Nick Raich at the Earnings Scout. But earnings growth has been above that average for a year and is expected to continue into 2019:

Q3 (est.): up 7.4 percent

Q4: (est.): up 6.8 percent

Q1’19 (est.): up 6.9 percent

Source: Thomson Reuters

This growth comes after several years of sub-par growth. Revenue growth was negative in 2016 and part of 2015.

“Companies are really good at maintaining profit growth in a near zero revenue environment. With revenue growth like this, it makes a company’s job much easier,” Raich told CNBC.

That’s because with revenue growth in the 7 percent to 8 percent range, an increase in costs of, say, 2 percent can be absorbed without killing margins.

Of course, if you have 1 percent revenue growth with a 2 percent increase in costs, then you have problems. But that is not what we are facing.

“Staying above-trend on revenues means economic growth remains strong and tax cuts are working,” Raich said.