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If a company’s share price is the sum of its future dividends (as per the dividend discount model) and those dividends can only be paid from earnings (as per company law), then equity investors are in for some bad news (as per the latest corporate earnings reports).
A second consecutive quarter of falling profits at the US’s biggest public companies is about to trigger a technical earnings recession, presage lower dividends and depress share prices.
If, however, share price movements are not so mathematical (as per recent market examples) and dividends not so essential (as per growth company performance), then there may be some better news (as per most wealth managers’ current analyses). A falling profit trend in the US, the UK or elsewhere need not mean your equity portfolio suffers.
For most of the summer, market watchers were warning that S&P 500 companies would report an average 2.8 per cent fall in their earnings for the second quarter, based on FactSet estimates, following a 0.3 per cent decline in the first three months of the year. And these numbers had been flattered by share buybacks, which artificially boosted earnings per share by 2.1 percentage points in the second quarter, according to Credit Suisse.
Earnings for FTSE 100 companies looked little better. According to the Profit Watch UK Q2 survey from broker The Share Centre, on a rolling 12-month basis the collective profits for companies outside the top 40 were down almost a fifth from their 2017 peak.
In both markets, dividend growth also appeared to be slowing — as measured by the Janus Henderson Global Dividend Index — as company profit margins came under pressure from rising wages and higher commodity prices. Analysts at Bank of America said: “We have been highlighting risk to margins from rising input costs for companies that don’t have pricing power, as well as for labour-intensive companies and sectors amid rising wages.” They reckoned non-financial companies would report net margins of 10.8 per cent in the second quarter, down from 11.5 per cent 12 months earlier, resulting in a full-year margin contraction. US hedge fund Bridgewater cautioned: “There is a decent chance that we are at a major turning point for corporate margins and, if that is correct, US equities have a major valuation problem.”
Fortunately for wealth managers running US and UK equity portfolios, margins, earnings and share prices are seldom so perfectly correlated. In fact, as companies were confirming lower first-quarter numbers, the S&P 500 was moving higher on forecasts that the US Federal Reserve would cut interest rates. It is one reason, along with the unreliability of earnings forecasts, that most managers are ignoring the short-term data and taking a longer-term view.
Fahad Kamal, chief market strategist at Kleinwort Hambros, points out that forecasts also suggest a rapid improvement to 6 per cent earnings growth in the fourth quarter of 2019 — making summer “probably the trough for earnings growth”. His advice to fellow managers and clients is therefore: “Take long-term positions and get asset allocation correct over the cycle. Trying to over-engineer positions based on the noise of any single earnings season is a poor strategy.” Not least because the noise can be misleading. “We have seen quite a gap between earnings expectations and out-turns in the past,” says Edward Park, deputy chief investment officer at Brooks Macdonald. “Indeed, over the past five years on average, actual earnings reported by S&P 500 companies have exceeded estimated earnings by +4.8 per cent.”
Alexandre Tavazzi, global strategist at Pictet Wealth Management, also notes that revisions to first-quarter earnings figures will probably mean there is no technical recession — at least, not until the third quarter. Or not at all, according to the analysis of HSBC Global Asset Management’s chief strategist Joseph Little. “The corporate profits data has softened and lost momentum, but across the range of indicators we look at there is little evidence of a profits recession,” he says. “For now, we remain pro-risk in our multi-asset portfolios, with some caution tactically after recent market strength.”
Still, at Hassium Asset Management, the absence of an earnings recession is no reason not to question equity valuations. Chief executive Yogesh Dewan expects the second-quarter earnings season will prove “underwhelming but not recessionary” but finds it “hard to see significant upside from current levels” based on company fundamentals. Hence he has reduced a previous overexposure to equities and is now marginally underweight — even if still preferring the US relative to Europe and Asia.
Similarly, other managers find plenty of non-earnings-related reasons to review portfolio allocations. “Among those, an outright trade war is a major threat,” says Tavazzi. It is a concern shared by Stéphane Monier, chief investment officer at Lombard Odier. “We reduced our equity allocation twice this year, first in February, then in May, bringing our global portfolio exposure to underweight,” he says. “These moves in our tactical positioning were a delicate balancing act as the persistent uncertainty around the US-China trade war kept weighing on trade.”
At the same time, though, he acknowledges the economic factor that kept shares rising in the first quarter: “There are some important positives as well, namely central banks’ accommodative monetary policies.”
Brooks Macdonald’s Park agrees — although earnings have been negative, this has been offset by an expansion in equity valuation multiples driven by likely US interest rate cuts. “Equities have been rerated on the expectation of central banks turning more dovish, in part seeking to mitigate against the slowdown in global trade,” he says. However, that adds another risk: “We do think on balance that central bank expectations are more likely to disappoint. We recently decided to reduce our global equities weighting.”
Earnings are not entirely irrelevant, though, nor inevitably a negative for equities. As Chris Beauchamp, chief market analyst at IG Group, correctly suggested in July, a positive surprise on depressed earnings forecasts might “support a push by the S&P 500 above the lofty 3000-mark”. Sometimes, it seems, models, laws and numbers behave as they should.
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