Only marginal declines in Emerging Market earnings suggest that fears of an imminent crisis are overblown
There is a relatively strong correlation between the direction of earnings forecasts and the short-term relative performance of equity markets. Over the last 12m, US markets have outperformed peers as Trump’s corporate tax reductions and fiscal stimulus have provided a tailwind for US earnings. In the UK, although weighted earnings forecasts have risen, UK stocks have trailed behind, impacted in our view by the negative domestic sentiment in terms of Brexit. Similarly, in continental Europe, market sentiment has been impacted by international and domestic political events. Intriguingly, the median emerging market forecast has only fallen by 2% since the Q1 peak, similar to the UK and Europe, suggesting fears of an imminent crisis are not at present feeding through to the corporate sector.
In addition to calculating weighted average earnings revisions shown in Exhibit 1, we also pay attention to the median earnings revision index. Both indices are useful and for active fund managers the median measure is often closer to the experience felt on the ground. In the UK for example, the high weighting towards oil and resources equities means that the progress of domestic stocks is largely hidden in a weighted average.
Exhibit 2 shows median earnings revision indices. We note that US estimates on this basis remain over 10% higher than a year ago, suggesting a broad-based impact from Trump’s tax reform. The initial impact from corporate tax cuts was followed by additional support from the acceleration of the US economy during Q2 as activity was boosted by the fiscal stimulus. In all other markets, the median earnings revision has been falling since Q1, albeit at a modest pace.
In the UK, there is the clear and present danger of a difficult Brexit process, which may yet cause significant political disruption and appears to have led investors to place something of a risk premium on UK equities. Brexit has also fuelled a significant increase in sterling volatility during the summer. The post-Brexit decline in sterling has not delivered a significant increase in exports but instead engineered a squeeze on domestic consumers, which may be contributing to the negative momentum in the median earnings revision index.
In continental Europe, the elevated level of uncertainty with respect to global trade may in turn be having an impact on sentiment towards eurozone exporters. It is noteworthy that the decline in the euro has not had a more positive impact on this sector. For emerging markets, although the possibility of serious problems as the US dollar strengthens has been well-flagged – and it is clear that this region is in the cross-hairs of US policy on trade – median earnings forecasts have fallen no faster than in the UK or continental Europe over the last 6 months. Median earnings growth for emerging markets is still expected to be 15% for 2018 and in 2019 EM growth is forecast at 13%, ahead of all major developed regions.
Despite the recent falls in emerging market and industrial commodities prices, forecasts for earnings growth globally are neither at very low levels nor declining at a rate which would in our view be consistent with rapid declines in equity markets.
We believe that robust earnings forecasts have been key to the benign de-rating process over the last 12m, where equity markets (outside the US) grow into currently extended valuations by moving sideways as profits increase. The US has been something of a special case due to tax cuts but the effect is a one-off for 2018; earnings forecasts for 2019 are in-line with those for Europe. There has been little change to 2018 earnings forecasts over the summer, which to us suggests a surplus of analyst commentary rather than actual damage to fundamentals, either from talk of a trade war or the risks of tighter US monetary policy.