The first-quarter earnings season got off to a good start. In developed markets (DM), global earnings momentum moved to its highest since mid-2014. The trend is less encouraging in emerging markets (EM), where earnings momentum has deteriorated over the past couple of weeks. Within DM the relative momentum remains strong for the Eurozone and Japan. In the US, earnings momentum is still negative but far less so than before. This type of convergence — where the strong regions remain strong and the weaker region improves — is encouraging.
Increased divergence between markets and fundamentals
US earnings show biggest upward surprise in two years
As of last week, 72% of US companies beat expectations, in line with previous quarters. The average earnings surprise was 6.7% and is spread across sectors. So far this is the largest upward surprise in the past two years. The biggest surprises are in Basic Materials (+14.8%), Utilities (+13%) and Financials (+9.3%). The smallest surprises are in Industrials (+3.7%) and Consumer Goods (+2.8%).
However, we are all familiar with the “management” of earnings expectations by corporate executives, especially in the US. The picture is more balanced if we look at the sales data, which are more difficult to massage. We see a small negative surprise of less than 1% with about half of the companies doing better than expected. From a sales level, this was the weakest season in more than 2 years. The impact of a strong dollar, a weak domestic economy and a slowdown in China has clearly impacted the top line. In fact, only three sectors manages a positive sales surprise: Health care (+1.2%), Energy (+7.7%) and Technology (+1.2%).
Strongest season in Europe since Q1 2014
In Europe, the earnings data flow is improving after a weak start. The average sales surprise by last week was 1.6% and the average earnings surprise was 8.9%, making this season the strongest since Q1 2014. However, a big part of these surprises is linked to the energy sector, which in the wake of low oil prices seems to have fared better than expected, with a sales surprise of 0% and a 45% earnings surprise. In absolute numbers energy sales dropped by 34% and earnings by 25%, dragging the total European sales growth figure below zero to -4.2%. All in all we would qualify the Eurozone earnings season as good but not stellar, given all the Q1 tailwinds provided by currencies, oil prices and interest rates.
Economic surprise trend less welcome
We also observe convergence in economic surprise data. Unlike the earnings convergence, however, this convergence is of a less welcome sort. US data continue to come in below expectations and in the past three weeks Eurozone data were also much weaker than expected. We do not want to read too much in it given seasonal factors and the fact that the European Central Bank (ECB)’s quantitative easing (QE) programme is less than two months old , but it is certainly a factor to watch very closely. Further relative weakness in Eurozone data could start to impact the relative performance of the Eurozone market. For now, the market seems to look through the weak economic data. Over the past couple of weeks, cyclical sectors have outperformed the more defensive sectors and the Eurozone continued to beat the US equity market.
Markets and fundamentals parting ways
The recent outperformance of cyclical sectors within equity space and the market’s “look-through” of economic data weakness are among the many dynamics that highlight a widening gap between markets and fundamentals. The current divergence between markets and fundamentals (see chart) will probably not persist indefinitely, but an assessment of what created it is a crucial determinant of the likely future convergence.
Economy becoming hard to read
The missing link on the fundamental side might be the inherent backward-looking nature of the data that investors use to assess the underlying state of the global economy. Significant changes in our economic system over the last decade may be making it much more difficult to read. Inflation, interest rates and wage and productivity growth have started to trend towards zero. Regulation and central banking have undergone regime changes, and political crises over fiscal policy have triggered huge bouts of uncertainty in Europe and in the US. Sanctions in west Russia and port strikes in the US have injected unpredictable swings in international trade flows.
Shift in investor mind-set
From a behavioural viewpoint, the increased uncertainty might be creating a new opportunity set rather than a reason to move investor portfolios to more defensive positions. Rather than increased buying of defensive-but-expensive assets like government bonds or stable cash-flow equity sectors, the investor mind-set seems to have shifted to relatively cheap, high-beta assets like cyclical equities, emerging markets and high-yield bonds. This is not necessarily fundamentally driven. The behavioural argument to start taking profits on the over-owned and the expensive parts of portfolios is not that difficult to find once the search for yield theme loses some of its momentum.
Data weakness carries some downside risk
Our preliminary impression is that both fundamental factors and behavioural trends are at play. While it is not easy to anticipate how it will evolve going forward, it seems too early to dramatically adapt our risk-on allocation stance. We do acknowledge that the likelihood of a persistent and broad-based search for yield has declined somewhat and we attach at least some downside growth risks to the weakness in the data.
Real estate overweight reduced from strong to medium
With these risks in mind, we moderated our allocation stance a bit by reducing our real estate overweight from strong to medium, while monitoring closely if further adjustments are needed to account for increasing volatility in government bond markets. Within real estate, we downgraded the overweight in European real estate from medium to small. Valuations are no longer attractive and price momentum has weakened. ECB QE and a strengthening labour market should offer some support.