Earnings forecasts: absence of a negative is not a positive

Profits forecasts for the US, UK and Eurozone have been stable for the last 2 months. In the context of last year’s relatively dramatic declines in profits expectations (the worst year in a decade) this is a welcome development for equity investors.

Exhibit 1: 2016 Forecast EPS index for US, UK and Europe ex UK

However, following the 12% rally in Western markets since February we believe the absence of a negative is no longer a positive; at this point we need to see positive earnings momentum for markets to make a sustained move higher. The lack of positive earnings momentum remains a key behind-the-scenes factor in the stuttering of global markets during April and May in our view. It is not just the apparent flip/flop of the US Fed which is driving markets.

Exhibit 2: Forecast 2016 Mining sector EPS index

From a sector perspective, Exhibit 2 shows the mining sector continues to benefit from upgrades as a result of the surprise turn in commodity prices since February. These increases are now largely in the rear view mirror in our view, especially as China clamps down on commodity price speculation. Though the global mining sector continues to trade at very modest price/book multiples relative to its long-run average, Exhibit 3, the sharp relief rally looks to have run its course, as forecasts have now caught up with the change in commodity prices.

Exhibit 3: Global mining price/book

For oil-related industries, the oil price rally since February has brought the oil price close to the marginal cost of US shale. Therefore, as another upward move would seem inconsistent with Saudi Arabia’s policy of maintaining market share, oil prices and earnings expectations seem unlikely to rise significantly above current levels and we would be cautious about chasing upward momentum in this sector.

More generally, the majority of sectors in each of the US, UK and Eurozone have seen relatively few earnings revisions over the last month. On balance, we believe the next revisions are more likely to be modest downgrades as manufacturing PMI indices in the US and UK indicate that economic activity has been decelerating recently, even if the Eurozone has been performing relatively better since the ECB’s expansion of its QE program, Exhibit 4.

Exhibit 4: Manufacturing PMI Indices in UK and UK tick lower

The lack of an investment theme based on earnings momentum leaves investors sitting on an uncomfortable combination of relatively high valuations and very modest sales and profits growth forecasts. Adding to the fear factor is the prospect of a US interest rate increase in June. While investors have on a number of occasions appeared rescued by a US Fed hyper-sensitive to financial market volatility, there is in our view nowhere near enough stress in global financial markets at present to justify another deferral for that reason alone.

Quick conclusions:

1. Earnings forecasts have stabilised but show little sign of upward momentum which we believe is necessary for further increases in market indices after the recent rally.
2. Equity markets have been quick to price-in the benefits of higher commodity prices and this tailwind is likely to ease in coming months.
3. The market has not fallen sufficiently for the US Fed to cite market volatility as a reason for delaying an interest rate increase in June.