By Caroline Valetkevitch
NEW YORK (Reuters) - Rising costs for companies are worrying investors already concerned about a step down in U.S. corporate profit growth next year as Wall Street's focus turns away from 2018's tax-fueled earnings boost.
Investors are on edge after a recent sharp pullback in U.S. equities, including the biggest daily drop in the Dow and S&P 500 since Feb. 8 on Wednesday. A spike in U.S. bond yields has renewed worries about rising interest rates and higher borrowing costs for companies and consumers.
Third-quarter reports will start pouring in this week from JPMorgan Chase & Co (NYSE:JPM), Wells Fargo (NYSE:WFC) & Co and others, with investors and analysts likely looking for outlooks on higher labor costs, a stronger dollar and the impact of tariffs on raw materials prices.
"It's going to come down to earnings. The big concern isn't really what third-quarter earnings numbers are, but really what the outlook for the fourth quarter and first quarters are," said Oliver Pursche, vice chairman and chief market strategist at Bruderman Asset Management in New York.
Even with Wednesday's selloff, the S&P 500 remains up 4.2 percent for the year. Strong earnings had helped stocks bounce back from steep drops in February and March and have kept investors largely optimistic about market valuations.
Analysts are projecting year-over-year profit growth of 21.4 percent for the third quarter, according to I/B/E/S data from Refinitiv, in part reflecting the sweeping tax overhaul approved by Congress late last year.
But this year's earnings growth, estimated at 23.1 percent, is likely the peak for the profit cycle, with growth forecast to slow to 10.3 percent in 2019 as the comparison period reflects a full year of lower corporate tax rates.
Cost pressures for companies are mounting, Lori Calvasina, RBC Capital Markets head of U.S. equity strategy, wrote in a note on Tuesday, adding that more than a third of S&P 500 companies have seen full-year margin expectations shrink since June.
Calvasina said she's been factoring in "back half deceleration" in 2018 margins and also a stronger dollar, but expects those issues have not been "fully baked into bottom up consensus estimates yet."
She and other strategists pointed to wage inflation as a key risk to profit margins, while companies already have cited worries about costs related to tariffs and the strengthening dollar.
In Friday's jobs report, the unemployment rate fell to near a 49-year low, suggesting the labor market has tightened further. But wages rose steadily, pointing to moderate inflation pressures.
The U.S. dollar index is up about 3.7 percent for the year so far and is now trading above year-ago levels. That could weigh on earnings from U.S. multinational companies.
Tensions between the United States and China, which already have imposed tariffs on each other's good, have meanwhile fueled concerns about higher costs for companies.
"What we're going to see is more of a focus on costs given that we've heard a lot rumblings" on that front, said Kristina Hooper, chief global market strategist at Invesco in New York.
"As tariffs proliferate, this becomes a bigger issue. It's cost of goods. Second, it's wage costs. We're not seeing it really borne out in the jobs data yet, but from my perspective, there have to be industries that are feeling and experiencing an increase in wage costs."
FedEx Corp (NYSE:FDX) last month cited employee compensation and other expenses as it reported quarterly earnings that missed Wall Street expectations.
To be sure, even a moderated pace of profit growth next year could still be considered good, given the huge boost from corporate tax cuts in 2018.
"The sooner we collectively re-anchor on that reality, the less disrupted the market could potentially be," Credit Suisse (SIX:CSGN) Chief U.S. Equity Strategist Jonathan Golub said on a conference call on Wednesday.