Equities bridging a gap in corporate performance - for now

Consensus profits forecasts on a global basis remain on a downward trend even as January’s recovery in risk assets such as equities and corporate debt continues into February. The primary reason for this at first sight paradoxical state of affairs is not hard to find; the US Fed has placed interest rates on pause and acknowledged the slowing of the global economy. Nevertheless, the clock is ticking on the persistence of the current profits downgrade cycle, which is also consistent with economic weakness evident outside the US. While not shifting our neutral stance on equities for the full year, near-term market performance is now in our view more tightly bound than usual to the turn in the direction of global profits forecasts. Therefore, in the short-term, we would not chase the rally, at least until there is some evidence of stabilization in earnings or positive news in respect of US/China trade.

Global consensus profits forecasts for 2019 remain unequivocally on downward trend during the first few weeks of the year based on our calculations, whether on the unweighted basis shown below or on a weighted basis. Emerging market forecasts have been declining the fastest, followed by Europe and finally the US where profits estimates have shown the greatest resilience. Within developed markets, the consensus forecast data also tracks economic surprise indices, which show weaker-than-expected economic data in the eurozone.

Exhibit 1: Unweighted consensus 2019 profits index continues to show negative momentum

Profits forecasts for emerging markets are falling meaningfully faster than developed peers. This is now a concern in our view in respect of the outlook for emerging markets which have rebounded strongly during Q119. Unlike developed markets where negative momentum has been unhelpful for sentiment but relatively modest in total, downgrades in emerging markets have cut deeper. For the emerging market industrials sector, for example, unweighted 2019 forecasts have in total fallen by 25% over the past 12 months.

Exhibit 2: Economic surprise indices highlight soft incoming eurozone data

The question for investors is in our view whether equities are bridging a short-term pause in profits momentum during H218-H119 or whether this lower corporate performance will persist. This persistence is exactly the same question that the ECB is currently split on, in terms of the overall economy. Recent press reports quoting anonymous ECB sources suggesting a degree of policy paralysis due to the upcoming replacement of Mario Draghi as ECB President are also unhelpful at this stage. The ECB is designed as a technocratic organization and internal fears that a change in policy now could later tie the hands of Draghi’s successor would appear at odds with its official mandate.

Fortunately for investors, the persistence of the recent economic weakness is also a question on which the US Fed has resolutely taken action, by pausing US rate increases and standing ready to adjust balance sheet policy should the need arise.

If the weakness in corporate earnings is temporary, there is a limited reason for concern given expectations of looser monetary policy over coming quarters, easier market valuations compared to 12m ago and still-positive projections for profits growth for the whole of 2019. On the other hand, should earnings forecasts continue to decline, the risk of a relapse in markets would build. As global equity markets have already risen by close to 5% since our more positive call in January we would not chase the rally here, at least until we are confident we can see an end to the downgrade cycle.
We would also continue to exercise caution in more cyclical sectors as well as those exposed to US/China trade dynamics. Ironically, a deal between the US and China on trade, market access, and intellectual property was in progress for many years prior to Trump’s appointment as US President. It is also in our view in Trump’s re-election interests to conclude a deal on trade during the next 6m; the timing, however, is very difficult to predict. We believe a deal would be taken positively by markets and would also help stabilize the corporate outlook, by eliminating trade uncertainty as an allowable external factor behind a profits downgrade.