After a sobering end to 2018, markets have revved up again, with the Nasdaq and S&P 500 rallying to record closing highs on April 23. Photo: AP
by Patrik Schowitz
by Patrik Schowitz

Will markets extend their record-breaking run into 2020? Watch what corporate profits tell us

  • Despite a recent surge, stock markets are roughly where they were before last year’s drop-off
  • Investors should watch what companies are saying about global conditions to anticipate what’s next

Records are there to be broken, as the saying goes, and not just among investors. Following the strong rally since the start of this year, global stock markets now seem to be in the process of breaking the record highs set in 2018.

In the US, the benchmark S&P 500 index has just done so, while the benchmark MSCI All-Country World Index is now just a touch below its record high set in early 2018 after stripping out currency effects. Lagging somewhat behind, the Chinese CSI 300 benchmark index is now a little less than 10 per cent from its 2018 high, although admittedly that is still well below its previous highs in 2015 and 2007. While this is good news for equity investors, it also reminds us that stocks’ strong start to this year mostly represents just a recovery from the weakness of late last year.
How quickly markets can set records, and by how much, will mostly depend on the outlook for corporate profits. The main reason of the market sell-off last year was a realisation among investors that a serious slowdown in global growth was under way, even sparking fears of an impending recession. Those recession fears receded quickly, mostly thanks to the sudden stop in the US rate-hiking cycle and Chinese economic stimulus.
This has allowed markets to bounce back equally quickly, but with economic growth around the globe now looking distinctly mediocre, the downgrading of corporate profit expectations has continued to drag on. Global profit growth expectations for 2019 aggregated from analysts’ company-level forecasts peaked at around 10 per cent back in October and have been steadily dropping. Roughly six months later, they now stand between 4 and 5 per cent, roughly half their peak level.

Other regions have seen falls of similar magnitude, with US profits growth now expected at less than 4 per cent, while closer to home Asia-ex-Japan profit growth has dropped to 5 per cent.

This means that the strong equity market returns year-to-date are entirely due to rising price-to-earnings ratios. For instance, the 12-month forward P/E ratio on Asia-ex Japan stocks has risen to just over 13.5x today, from a low of less than 10x at the start of the year. Admittedly, this only takes valuations back to where they were in early 2018, but that was when the growth outlook was brighter than today, and it is appreciably above the long-run average of 12x.

Similarly in the US, the 12-month forward P/E ratio is now at nearly 17x, compared to a long-run average of around 15.5x. To be fair, these valuation levels look “somewhat stretched” rather than “crazy”, but it looks unlikely that further rises in valuations can now be the main driver taking markets higher, given how uncertain the economic outlook remains. What markets now need most of all is better news on profits.

Fortunately, there does seem to be some good news on the horizon on this front. Earnings downgrades seem to be coming to an end across the globe, with expectations stabilising in recent weeks. And the mid-single-digit growth rates now predicted for most regions seem commensurate with the current mediocre-but-not-terrible macro environment.

In a few cases, most notably the US and perhaps even Japan, growth expectations in the low-single digits now even look a little too pessimistic, which might allow for some limited positive surprises.

Thanks to two crashes of its now-grounded 737 MAX 8 plane, Boeing on Wednesday announced its worst quarterly earnings in years, as well as an unclear sales and profit forecast. Photo: Reuters

One remaining worry is analysts’ too-optimistic outlook for 2020. They currently predict an unrealistic re-acceleration and doubling of the profit growth rate back to the double-digits. Of course, 2020 is still a way away and investors may not worry about this issue until later this year. Still, as these expectations come back down to reality, this should be a headwind to sentiment and another reason why one should be sceptical that stock market valuations will rise significantly.

The corporate reporting season that is under way across the globe offers insights into how companies themselves see the profit outlook. After the steep downgrades in forecasts, results for the first quarter are likely to surprise pleasantly, as analysts often overshoot in both directions.

But instead of focusing on largely meaningless statistics of how many or by how much companies beat analysts’ earnings forecasts for the quarter, investors should focus on companies’ commentaries on key issues such as growth, the impact of the global trade tensions and rising wages across much of the developed world. If these confirm that earnings can continue to grow at around the currently-expected mid-single-digit pace, then stock markets look set to leave behind last year’s record levels.

Patrik Schowitz is a global multi-asset strategist at JP Morgan Asset Management

This article appeared in the South China Morning Post print edition as: Look beyond corporate profit outlook for market direction