Over the past weeks, global earnings momentum has dropped significantly. We have also revised our earnings growth estimate for the Eurozone this year from +15% to +11%.
Commodity-related sectors are the main underperformers
Drop in global earnings momentum…
Earnings momentum can be described as the ratio of upgrades versus downgrades of corporate earnings estimates by analysts. Falling momentum therefore means that analysts are downwardly revising their estimates. Earnings momentum fell in both developed and emerging markets (EM). Most noticeable was the drop in continental Europe. We expect more downward earnings revisions for 2015 in the coming weeks.
From a sector point of view, we observe declining earnings momentum in consumer staples, energy and telecom and rising momentum in IT and utilities. Sectors with the weakest momentum are consumer staples, energy and financials. Health care and utilities have the strongest earnings momentum. However, no single global sector has positive earnings momentum at the moment.
…caused by EM, commodity sell-off and euro appreciation
This drop in earnings expectations can be attributed to three factors. The first one is related to the impact of the growth slowdown in emerging markets. Indeed, given that Eurozone companies realize approximately 30% of their revenues in emerging markets – and half of that in Asia ex Japan – the EM slowdown will not pass unnoticed. The sectors in Europe having the biggest sales exposure are consumer staples, materials, technology and consumer discretionary. Sectors with relatively low exposure are real estate, financials and health care. This has already impacted the relative performance of these two groups of sectors.
The second factor is linked to the fall in cyclical commodity prices. The drop in the oil price will lead to sharply lower earnings for the sector. Currently, the consensus among analysts’ estimates for 2015 is for a 45% drop in earnings for the global energy sector and a 12% decline for the global materials sector. In the second quarter (Q2), these two sectors represented approximately 10% of the total earnings of the S&P500 index. These trends also seem largely discounted in the relative performance of both sectors. Year-to-date, the energy sector has lagged the global equity market by 16% and the materials sector underperformed by 10%.
The third factor is related to the recent appreciation of the euro against most other currencies, especially in August. This might also explain why recently US earnings momentum looks more stable than Europe. However, on a yearly average, currencies remain a tailwind for Eurozone companies and a headwind for US companies.
No material impact on the domestic economy
These three elements explain the substantial downward revision in the earnings outlook, in particular for European companies. We have also revised our earnings growth estimate for the Eurozone this year from +15% to +11%. It is interesting to note that these revisions have nothing to do with the domestic economy, which remains strong. We perceive little contagion from the aforementioned factors on the developed economies and the Eurozone economy in particular. Eurozone Q2 GDP growth was 0.4% compared to the first quarter and indications for Q3 are positive. Employment is increasing while July retail sales were decent, showing that consumers continued to spend despite Greek and Chinese turmoil. Confidence indicators such as the PMI and the European Commission sentiment survey have improved slightly in July and August, compared to Q2. Moreover, bank lending to non-financial businesses is finally recovering, suggesting that the third quarter may bring a pickup in investment. That would be an especially welcome sign of a broadening recovery.
Financial conditions and confidence could be impacted
Nevertheless, we should always be aware of the possibility of so-called second-round effects, which generally come with a time lag.
A first channel runs through a tightening of financial conditions. This happened over the past month, as reflected by a stronger euro and rising bond yields, but seems to have stabilised since then. After the latest ECB meeting early September, Mario Draghi made clear that the central bank will step up its quantitative easing (QE) effort if and when needed. In addition, the fact that the European credit market is mainly a bank-based system means that the recent tightening of financial conditions has not impacted credit conditions. On the contrary, the dynamics of the European credit market are improving.
A second transmission channel could run through a deterioration of confidence, resulting in consumers and companies pushing the brakes. Time will tell, but for the time being there is no hard evidence of such a thing happening. The only exception is in the US oil sector, where indeed capital expenditure is being cut substantially and where an increasing number of oil companies are experiencing difficulties in servicing their debt.
Too early to call the death of the bull market
All in all, it seems premature to call the death of the bull market. Developed market macro fundamentals are resisting well, equity risk premiums are attractive and market technicals are supportive. This is illustrated by the low level of the bull/bear ratio, implied volatility levels above 25%, a rising put/call ratio and the generally cautious positioning of investors. An EM debt crisis and China risk were the top two risks put forward by investors during the August fund manager survey conducted by Bank of America Merrill Lynch.
Finally, there is the meeting of the Federal Open Market Committee (FOMC) this Wednesday and Thursday. The odds of a first rate hike on Thursday have fallen from 54% early August to 23% today. FOMC members still seem to be divided about a first hike this month. Labour market data do warrant a rate increase, but the recent financial and emerging market turmoil could plead for a delay. The Fed appears to remain on track to raise rates this year and after this week still has two occasions – October and December – to do so. Our base case remains for a rate hike this year, provided market turmoil does not return with a vengeance. Yet we are not overly worried should the Fed hike this week, as it would be a sign of confidence in the strength of the recovery, ultimately supporting equity market sentiment.