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Following a “V-shaped” recovery from the sharp market sell-off late last year, US equities now face a reality check as we head into the Q1 earnings reporting season. Although early earnings results have broadly met expectations, there seems more downside than upside risk to the earnings outlook as this year progresses.
US Earnings: 2018 is a tough year to beat
The chart below details rolling monthly consensus estimates for the calendar year US corporate earnings, along with the derived level of “forward earnings” that these estimates generate over time1. As evident, following a flat period for earnings in 2014 and 2015, US forward earnings have enjoyed a solid upturn since early 2016, thanks to expectations for solid annual earnings growth that have been largely maintained. Strong tech sector earnings and a rebound in global oil prices helped in this regard.
What’s more, earnings received a further boost early last year thanks to deep US corporate tax cuts. In recent months, however, the outlook has turned more negative, with earnings downgrades that have conspired to flatten out forward earnings since late last year. Based on current expectations (as at 22 April), 2019 earnings will be up by only around 2% on 2018 levels, though growth is expected to accelerate to 11% in 2020. If upheld, these expectations would imply still reasonable 7% growth in forward earnings over the remainder of 2019.
Of course, this begs the question: will these expectations be maintained?
Although it’s early days (with only 15% of S&P 500 companies having reported), the Q1 earnings season so far at least appears no worse than feared. According to FactSet, 78% of companies have so far beaten earnings estimates – which is a little above the 5-year average of 72%, and expected overall Q1 market earnings have held up so far. Among sectors, the weakest earnings outlook surrounds energy (related to weakening oil prices) and technology (related to a weakening demand for cars, personal computers and smartphones).
The big challenge, as seen in the chart below, is that the market is counting on a quick rebound in earnings over the remainder of the year – even though current estimates suggest the March quarter will already mark the second successive decline in quarterly earnings. Of course, US economic growth and corporate earnings will also not benefit from tax cuts this year, and tight labour markets are continuing to place upward pressure on labour costs.
Of course, one potential upside risk to earnings is a strong rebound in oil prices (especially now that the US seems intent on toughening restrictions on Iranian exports), but slower global growth and Saudi Arabia’s lingering ability to increase output if need be may well cap the upside. Within the technology sector, the important semiconductor market also continues to face the challenge of a maturing in demand for PCs and smartphones – along with the bitcoin mining bust2.
US Equities at best appear fully valued
As seen in the chart below, the strong rebound in equity prices along with a flattening out in forward earnings has caused the US market’s price-to-forward earnings ratio to reach 16.8 by late April. Although that’s still 6.5% below the highs of 18 seen in early 2018, it is still toward the upper end of valuations achieved over the past decade or so. With US 10-year bond yields also no longer especially low (at least by the standards of recent years), the equity-to-bond yield gap is now also back toward the low end of its range over the past decade.
All up, if current earnings expectations are maintained and PE valuations return to the highs of early last year, US equities could still enjoy further solid gains this year. That said, with increasing downside risks to US corporate earnings and an apparent fully valued market, further potential upside to US equities may well be more limited. Although this need not suggest a wrenching bear market or US recession is around the corner, it could suggest a period of broadly sideways movement (albeit with periods of upside and downside volatility) could be ahead of us.
Investment Implications – buy quality!
As previously explained, one equity investment exposure that has tended to do well in “late cycle” periods – are we are now possibly entering – is “quality”, or companies with relatively high and historically stable returns on equity with only moderate leverage. This possibly reflects a desire by investors to gravitate toward companies with strong balance sheets and durable profitability in times of heightened uncertainty.
Recognising the positive attributes of the Quality factor, BetaShares has recently introduced a Quality factor product over global shares in our QLTY ETF – BetaShares Global Quality Leader ETF. QLTY aims to track the iSTOXX MUTB Global Ex-Australia Quality Leaders Index. More details on QTLY can be found here.
1. 12-month forward earnings are a rolling weighted average of consensus earnings per share estimates for both the current and following year, with the weight attached to the following year increasing (and the weight for the current financial year decreasing) as the new year approaches. In the case of the United States, for example, forward earnings as at June-2018 would be an equal-weighted average of earnings in both the 2018 and 2019 calendar years. By December 2018, forward earnings fully reflected expected earnings for 2019.
2. It should be noted that former tech companies such as Alphabet and Facebook are now classified within the communications sector.