Earnings season – ‘some welcome surprises?’

In this month’s video Investment Director Ritu Vohora, offers some key takeaways following the latest round of quarterly earnings announcements. Results were better than feared, with actual reported earnings surprising positively, particularly in the US. The economic backdrop remains supportive but earnings growth looks set to moderate in 2019, so selectivity will be important.

This March marks the ten year anniversary of the longest equity bull market, so it seems fitting that markets closed out February on a high.

Equity markets extended the new year rally and finished the bemonth in positive territory, as investors brushed off concerns about slowing global growth and US-China trade tensions, whilst welcoming some positive earnings surprises from the latest round of quarterly results. This helped the MSCI AC World Index deliver year-to-date returns of over 10% (in USD terms) – this marks the third strongest start to a year on record.

All major regional equity markets registered positive returns over the month, with the exception of LATAM. Developed markets outperformed emerging markets overall – with the latter only delivering marginal gains in February. However, domestic Chinese shares bucked the trend, up 14% (in USD terms).

Brent crude was up over 6% in February and has returned just shy of 23% year to date. Elsewhere, renewed risk appetite supported global high yield, but weighed on 10-year US treasuries and German bunds during the month.

Italian government bonds sold off the most, after the European Commission cut Italy’s 2019 growth forecast amid concerns over its outlook and weak fiscal position. The move saw the yield spread over German bunds climb to 289 basis points.

From a sector perspective, technology was the standout performer in February – with software, semiconductors and tech hardware stocks all delivering strong returns. Cyclical sectors such as industrials pulled ahead of more defensive areas of the market, with consumer staples and healthcare lagging over the month.

With the lion’s share of fourth-quarter earnings results now behind us, what are some of the key observations and takeaways?

Investors have become accustomed to a blistering pace of earnings growth in the US. Profits per share are expected to have grown by 23% for 2018, with a compound annual rate of 12% over the past ten years. Recently, however, the momentum has slowed, and there has even been talk of an ‘earnings recession’. Amid signs of slowing economic growth, trade worries and concerns around the path of interest rates, we started to see significant downward revisions to earnings forecasts in the fourth quarter.

For S&P500 companies, aggregate year-on-year quarterly earnings growth estimates fell from more than 18% in October last year to less than 12% by mid-January this year. This marked a break in the trend we witnessed throughout 2018, with upward revisions to consensus forecasts. Encouragingly, as companies reported actual fourth-quarter earnings, the ‘blended’ year-on-year earnings growth rate inflected higher.

In addition, the price action following announcements has been positive, suggesting that investors had been prepared for the worst and over-discounted the weakness. Indeed, markets rewarded positive earnings surprises more than average and punished negative earnings surprises less than average. In aggregate, companies that reported forecast-beating results were rewarded with the best ‘one-day’ performance since the beginning of 2016, whilst the magnitude of downward price moves for missing estimates or lowering guidance was smaller in comparison.

This is in stark contrast to last year’s first-quarter results, when 80% of S&P500 companies topped forecasts. However, much of the positive news, such as the windfall from Trump’s tax reforms, was already priced in. The market reaction to positive surprises was relatively lacklustre, while investors punished those companies that undershot expectations.

Year-to-date, cyclical sectors have led equity market gains, but earnings ‘beats’ have been broad-based, with both defensive and cyclical sectors surprising to the upside. In the US, nine sectors recorded positive quarterly EPS growth year on year, five of which posted double-digit growth.

Over 70% of S&P500 companies delivered earnings ‘beats’; industrials and technology had the highest percentage of above-consensus earnings, while energy and materials reported the lowest earnings ‘beats’, with around half of the companies in these sectors topping forecasts. Interestingly, energy companies that did report earnings ‘beats’ also delivered the biggest earnings surprises.

Earnings for S&P500 companies overall surprised positively by 3%. Results were softer in Europe and Japan, but earnings still surprised to the upside, with more than 50% of companies delivering earnings ‘beats’.

Company revenues have also been holding up relatively well. Nearly 60% of S&P500 companies beat sales estimates. Aggregate sales growth came in at around +6% year on year, with all sectors except technology reporting positive growth.

Healthcare and industrials led the sales ‘beats’.

In Europe, 65% of Stoxx 600 companies delivered sales ‘beats’. The weaker euro has likely helped companies’ topline in the fourth quarter, leading to a higher proportion of sales beats in the region versus the US.

While earnings growth is set to moderate in 2019, tracking the more subdued growth outlook, we still expect to see companies (in aggregate) reporting growth, but selectivity becomes more important as cost pressures start to bite into margins.

Importantly, earnings pauses aren’t unusual, and markets tend to take these slowdowns in their stride. At key turning points in history, in 1998, 2003, 2009 and 2016, equity markets continued to trend upwards, ahead of earnings revisions turning positive. So we don’t need to see positive earnings revisions for equity markets to gain ground in 2019.

The backdrop remains supportive of continued positive earnings and revenue growth, while ongoing accommodative monetary policy – particularly a more dovish Fed – should provide a welcome tailwind for companies and investors alike.


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