When earnings are up, why are investors anticipating a stock market downturn?
Patrik Schowitz says current valuations amid a solid growth environment, particularly reflected in strong corporate earnings in the US, make equities attractive
Global equity markets have struggled to gain momentum this year as investors have fretted about the end of the long-running bull market and second-guessed the state of the global economic cycle. However, given that economic fundamentals remain pretty solid, it is probably too early to worry.
Perhaps the most important part of market fundamentals are corporate profits – and here we are currently seeing an impressive display of strength in the quarterly earnings season, particularly so in the US. With nearly two-thirds of the US’ S&P 500 companies having reported, Bloomberg shows a record-breaking 87 per cent have beaten analysts’ profits expectations and, in aggregate, these companies are reporting profits that are up by around 25 per cent from a year ago, and about 5 per cent ahead of expectations, which itself is a very high level of positive surprise historically.
Admittedly, other regions cannot keep up with this spectacular display: in Japan, earnings thus far have merely been solidly above expectations, with growth rates in the mid-single digits, and in Europe, profits have actually disappointed a little for most companies.
But, importantly, in all three regions, companies’ top-line sales have been robust and stronger than analysts expected – a clear hint that analysts remain too cautious on economic activity and demand. And while a number of companies in specific sectors have warned of the potential impact on profits from trade frictions, so far this has not reached levels that should spook the wider market.
So why do investors seem to be unconvinced in the face of these robust numbers? One issue is that investors often think only very loosely about the distinction between earnings levels and growth rates. Therefore we hear many investors worry about “peak earnings”, when in reality that is not in sight for the next few years.
Let’s put the wider global profit outlook into context: in most major markets, earnings growth rates either have peaked earlier this year or – in the case of the US – look like they will be peaking soon. This is normal. As the saying goes, trees don’t grow to the sky.
After a year of extraordinary profit growth such as 2017, it would be unrealistic to expect further acceleration. In fact, helped by the ongoing US strength, 2018 is showing only a surprisingly small slowdown in global profit growth, to around 15 per cent on current estimates. Emerging market profit growth this year should be very similar, in the mid-teens.
And looking into next year, while a further slowing in growth rates – to perhaps the high single digits – is to be expected, we are a long way from falling profits. We will probably have to wait until the end of the economic cycle to see that – still several years away in all likelihood.
So what about the argument that all this has already been discounted and priced in? There is definitely some truth to that. The rally in shares last year was to a large degree driven by the anticipation of strong earnings growth to come. And equity markets usually do prefer accelerating growth to decelerating growth – as this year’s experience also shows.
Still, stock prices have been lagging behind earnings, and thus equities are getting cheaper quickly. As a result, developed equity markets are now trading at just 15.5 times earnings over the next 12 months. This is down from 17 times at the start of this year, and now actually slightly below the 30-year average of 16 times.
Emerging market equities are now trading at just 11 times 12-month forward earnings, almost perfectly in line with the 20-year average, and well below the 30-year average of 13 times. These valuation levels may not classify as super cheap, but in the context of a still-solid growth environment, they do look pretty attractive.
Investors have to balance risks and rewards, and risks remain elevated, driven in particular by the ongoing global trade frictions. Therefore, it is understandable that investors may demand something of a valuation discount for holding equities, but they should also not discount too much the solid earnings fundamentals underpinning positive market prospects.
Patrik Schowitz is global multi-asset strategist at JP Morgan Asset Management