Every quarter, companies deliver a report card on their performance over the past three months. This has become quite a game between companies and the equity market. Some deride the short-term focus on earnings, while others think it is quite desirable for companies to provide shareholders with regular updates and guidance.
Ahead of the latest corporate earnings season, expectations in the US and Europe are not looking good with negative profits growth forecast compared with the same time a year ago. A reader may well ask why equities have rallied so hard since late December, with the Stoxx Europe 600 index having climbed to a seven-month high this week, while the S&P 500 (.SPX) sits just shy of its record peak from last September?
The answer resides in the market’s knack of looking ahead. After a poor first quarter, expectations for S&P 500 earnings growth in the second quarter are currently flat, while the Stoxx 600 is seen picking up towards 5 per cent. Beyond that horizon, estimates improve as they often do, with the caveat that the task of accurately assessing the trajectory of earnings beyond six months becomes far harder. Still, faith that earnings growth will accelerate later this year is based on the view that central banks have recognised the limits of tightening policy and are on standby to provide further easing.
Prospects of a Sino-US trade deal alongside an improving tone in economic data from China and service sector figures for the eurozone add credence to such thinking. US data showing a moderation in growth towards 2 per cent is also supportive as the great fear earlier this year was a hard landing, with interest-rate sensitive sectors such as housing and autos setting the pace.
Earnings guidance from companies for the rest of the year, alongside the tone of incoming data, will clarify whether these green shoots are indeed sustainable.
Moreover, the slashing of earnings estimates in recent months does provide room for improvement and it is not hard to suspect that’s a likely outcome should the economy show resilience. This is one of Wall Street’s favourite party tricks ahead of every earnings season, lowballing expectations to spur an upside surprise and a positive share price reaction.
Reinforcing the current market theme of looking into the future, just a few weeks ago shares in FedEx (FDX) slid after the bellwether for global economic activity reported quarterly results below its own expectations and once more lowered its full-year earnings outlook. Investors duly bought the dip and FedEx shares have subsequently rebounded, reflecting market expectations that global activity is coming back.
Or at least that is the hope as global equities rally. The strong performance across credit markets this year also requires robust data that helps offset a margin squeeze in order to justify the current tight level of spreads or risk premiums, given the hefty rise in borrowing among companies.
What is particularly interesting from perusing buyside and strategy research and talking with investors is how the combination of low government bond yields and the absence of a macro shock has many keeping faith with equities and credit.
Find solid companies that increase their dividends is one tenet of faith at the moment. Or head towards emerging markets, where many economies have low inflation that provides their central banks with a lot more room than their developed world peers to cut interest rates, should global growth slow further.
The key question and one duly posed by Alan Ruskin at Deutsche Bank this week is: “Even with a recovery, how assured is a longer-term global recovery?”
A hard landing is now priced out by markets courtesy of the policy U-turns by central banks, but many investors are understandably wary given the very mature economic cycle. This is highlighted by institutional investors’ unwillingness to chase the rebound in risk assets. State Street’s global investor confidence index shows these type of investors are the most risk-averse since 2012.
Markets will look beyond a disappointing run of earnings results this month and perhaps into the summer, but pressure on profit margins and a modest bounce in economic activity poses a challenge to equities and credit, which have enjoyed a significant rally so far this year.
While the likes of BlackRock are sticking with equities from here — which given their massive role in markets is hardly surprising — the asset manager does counsel a nuanced approach:
“Investors might consider rebalancing, locking in profits in some of the strongest performers year-to-date.”
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