Markets pause to reflect on better-than-feared earnings

Key takeaways

• Low expectations for this earnings season and global uncertainties have translated into unambitious guidance for the rest of this year
• The season looks like a reaction to the end of 2018’s markets. Valuations do not point to a 2019 recession
• Investors worry about three potential threats; another US government shut down, an escalation in US/China trade tensions and the UK’s Brexit uncertainty
• There is still ground for stocks, particularly FAANGs, to make up in markets
• If the US avoids another US government shutdown, US-China trade relations improve and the UK avoids a no-deal Brexit, the markets’ low-level expectations may continue into another earnings season and translate into positive surprises and higher markets.

As we pass the half-way point of the fourth quarter’s earnings, it’s time to draw some conclusions from the numbers so far. At the time of writing, 60% of S&P500 companies have now reported, while 35% of European and 60% of Japanese companies have done so.

Expectations for this earnings season were so low that a number of companies have been rewarded for doing little more than delivering. It’s also clear that given the global uncertainties, companies see no reason to increase their guidance for the rest of this year. This is in contrast to third-quarter earnings, when firms were punished by markets for providing anything less than strong guidance, earnings and revenues (see our 14 November article).

A global Fund Managers’ Survey published last month found that 60% of investors expected a weaker economy over the next year, the worst measure since July 2008, and two months before the collapse of Lehman Brothers. Rather than a recession, the survey points to a ‘secular stagnation’ with below-trend growth.

In the context of late 2018’s falling markets, this is not surprising. The global decline of 13% in stock markets in the last quarter of 2018 was the worst fall since 2011’s third quarter. The December fall in the S&P500 Index was the worst December drop since 1931. Yet this downturn was followed by a rally of 7.76% year to date in the MSCI World Index, and more than 8% ytd in the S&P500, leaving many investors in a wait-and-see phase. With some company results greeted with rising stock prices, the earnings season looks more about a reaction of the end of 2018 than a reflection of valuations for 2019. Still, valuations do not appear to point to a 2019 recession (see chart 1).

Investors are paying attention to three potential threats. Firstly, and most immediately, a potential second US government shut down which may happen as early as 15 February over a disagreement between the US President and Democrats about how to manage Trump’s demand for a border wall with Mexico. Secondly, the news that there are no face-to-face trade talks planned between the US and China ahead of a 1 March deadline for an increase in tariffs. Finally, the UK’s political uncertainty around its 29 March deadline for leaving the European Union.

Results in US, Europe, Japan and EMs

FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) have largely beaten expectations while semiconductors, retail, healthcare and biotech have disappointed. Alphabet, Google Inc.’s parent, beat earnings and revenue, but the stock lost ground following results. Twitter meanwhile reported earnings and revenue above expectations, but disappointed the market by saying it sees expenses rising. In industrials, estimates are roughly in line to slightly lower with forecasts of a 2019 slowdown while emerging markets, especially India and Brazil offering some growth. The healthcare sector has underperformed wider markets with lower-than-expected guidance, complicated by a range of pricing, political, pipeline and merger uncertainties. In the software and IT services sectors Apple surprised the market with a profit warning at the beginning of the year, before reporting a 5% fall in total sales at the end of January. Interestingly, since the early January warning the shares have rallied 20%.

Many companies in the S&P 500, including Netflix Inc., Delta Air Lines Inc. and Estée Lauder Cos., have fallen short of first-quarter earnings forecasts, blaming the worsening outlook for the global economy and uncertainty over US trade policy with China.

Any signs that the US and China are stepping back from escalating their trade dispute would play in favour of sectors including manufacturing, especially machinery, mining, metals, automobiles and aerospace, to name a few. Conversely, should US-China tensions deteriorate, then a broader exposure to US equities, relative to the rest of the world, would be appropriate.

EPS expectations

Consensus earnings per share (EPS) point to growth of 5% for 2019 among the S&P500, according to Bloomberg calculations. That would provide respectable returns for the year, but depends on key events this year not upsetting the global economy. The outlook for the STOXX Europe 600, of a 9% growth, is less reliable and likely to be revised downward. Meanwhile, the Japan TOPIX EPS are forecast to rise 1% and in the MSCI Emerging Markets, advance by 5%.

The Federal Reserve (Fed) reassured markets by removing its hiking bias from its January statement. The equity rebound has objectively not run its course, and if markets were to prove more robust this year, a Fed hike cannot be excluded. The S&P 500 Index is still 7% below its September high and if earnings continue to grow, albeit at a slower pace than in 2018, there is every chance that this level will be revisited. However, in the very near term, we expect markets to go through a period of consolidation.

The caution displayed by the analyst community this earnings season may persist into the first quarter of 2019. If another US government shutdown is averted, US-China trade relations do not deteriorate and the UK finds a way to avoid a no-deal Brexit, a lower bar may again see companies rewarded for positive earnings, and more confident outlooks.