Despite great expectations of economic recovery over the past few years, corporate earnings growth has been in relatively short supply. Having rebounded strongly after the financial crisis, global earnings per share (EPS) improvement trends have been muted or poor since 2011.
As equity markets and equity valuations have been spurred on by renewed expectations of economic recovery, more and more emphasis is being placed on corporate earnings fundamentals to improve. So, are we at a point of improvement or setting ourselves up for disappointment?
The data does point toward improvement as we look at an aggregate level. Purchasing managers’ indexes (PMIs) have been rising since the depths of last summer, and while this is as much an expression of sentiment as activity, they tend to be a solid predictor of earnings improvement.
Corporate confidence is certainly rising—in the U.S. especially—and this is leading to ongoing positive trends in employment, together with some signs that corporate investment may be rising from the depths. These trends—if durable—are important with respect to the ability of the equity cycle to mature in a positive way. Expectations are more positive in terms of how a better growth environment may create opportunities for companies to begin growing revenues and profits once more after a very lean period.
While the upturn in corporate sentiment has been impressively broad-based, the most notable contributor has been the near-term improvement from the energy sector. This is due to the rolling over of extreme weakness in oil prices in the first quarter of 2016 leading to a not-insignificant bounce in earnings.
While helpful in boosting sentiment around fundamental recovery, we continue to see the path of oil prices as downward over the medium term as U.S. production increases and oversupply to the market remains. In light of these new market dynamics, we believe the rebound in energy prices may be more temporary than the market expects. This view naturally gives us some caution in terms of pricing any long-term recurrence in earnings growth trends within the energy sector.
One important factor that will influence earnings growth in the U.S. will be the ability of corporates to prosper from a gradually improving macroeconomic environment via revenue growth while defending profit margins. With inflation and wages rising gently, and interest rates likely to move higher at a cost to debt servicing, pricing power at the individual company level is going to be an important factor.
The ideal outlook for U.S. growth and profitability is of a slow-burning improvement phase, without an excessive injection of policy-driven inflation. With the extremes of Donald Trump’s economic policy being deferred, delayed, or ditched, this scenario looks more likely than not. However, we remain vigilant over the potential sources of any inflation shock, given the likely negative consequences for corporate profits.
EUROPE—FINALLY SOME IMPROVEMENT!
It is well documented that European profits have steadfastly refused to grow over recent years. While perplexing at times, this disappointment has part of its foundation in structural change, which has been exerted from long-term challenges in the energy, materials, and financials sectors (Figure 4).
The year-on-year disappointment has been a harsh reminder to remain skeptical of consensus estimates, but we have finally seen a turn in profits for the commodity-oriented sectors. Meanwhile, European PMIs hitting new cycle highs is indicative of a better profitability backdrop for many financial companies.
While Europe is not the most cyclical of equity markets (Japan and emerging markets both have more earnings sensitivity to an improving macro backdrop), the prospect of sales growth returning to Europe is an intriguing one, given that operating leverage is high (Figure 4) and should drive profits sharply upward on any semblance of a topline sales recovery. There have been times when we have been highly skeptical of rumors of fundamental improvement coming to Europe, but on this occasion, an upturn in corporate profits has a good chance of longevity.
IS JAPAN ABOUT TO SHINE?
Japanese companies have been recording double-digit profit growth over the past two quarters, with the fourth quarter of 2016 delivering a seasonally adjusted profit totaling ¥19.8tn—a record in absolute terms. While global profit growth has been scarce in recent years, Japan has been the one market that has delivered on its cyclical corporate profits promise (Figure 5), even in spite of anemic domestic and global economic growth trends. For the cyclical optimists, Japan certainly embodies a strong later-cycle earnings growth story.
Earnings momentum and earnings revisions have certainly improved from their midcycle slump in late 2015/early 2016, with a weakening yen providing a tailwind to export growth. Japan has also been evolving domestically, in part due to the efforts of policymakers to incentivize efficiency and profitability via legislation and not-so-subtle, coercion to modernize. Capital allocation policy is the most notable way to demonstrate this change, with dividends and share buybacks hitting all-time highs in 2016 (Figure 6).
While Japan’s domestic backdrop has yet to catch fire as wages remain broadly stagnant and inflation stubbornly low, the capital return element of corporates shows the flip side of widely reported doubts surrounding the success of Abenomics.
While gross domestic product growth has remained low for Japan, it is the improvement in corporate governance and profitability that has been rewarded. We therefore believe the bottom-up picture warrants more attention from investors in a macro-obsessed world. Japan has certainly acted as an important reminder of the differences between economic and equity fundamentals and has been instrumental in Japan outperforming most major markets since 2012.
PULLING IT ALL TOGETHER
While improvement is likely to evolve, individually and collectively, over the remainder of 2017, and already we are seeing encouraging signs (Figure 7), one ongoing concern centers on consensus expectations. Earnings growth estimates have been perennially too high throughout the last five years, and disappointment will inevitably emerge. In a world of dispersed corporate prospects, the opportunity to refresh portfolios upon normalizing volatility and to select individual stocks as they react more aggressively to earnings outcomes will be paramount.
While any change in tone (macroeconomic or at a corporate level) may halt the upward momentum of markets in the near term, we would advocate careful contrarianism in upgrading portfolios as we remain optimistic over the medium term.
For stock pickers at least, a return to fundamentals driving stocks will come as a relief and makes some sense following a year in which politically inspired sentiment and macroeconomics have driven markets from one extreme to another. Ultimately, while the evolving patterns of economic growth, inflation, and interest rates will remain a source of intense focus and debate, 2017 will be defined equally, if not more, by earnings delivery (or the lack of it) as reality continues to confront rhetoric.
Laurence Taylor – Portfolio Specialist, Global Equities – T. Rowe Price