Earnings forecasts: Reassuringly stable?

Recent trends in consensus earnings forecasts highlight analysts’ confidence in corporate performance for 2016, even as GDP forecasts continue to decline. For now, it appears that the global phenomenon of steadily declining earnings forecasts, a factor behind the relatively weak 2015 equity market performance, has ebbed. There also remains no observable impact on aggregate UK earnings forecasts from Brexit to date, although as we have previously noted for the UK, FX benefits for exporters have offset modest downgrades to sectors focused on the domestic economy.

Exhibit 1: 2016 Consensus GDP Growth Forecasts

Developed market equity valuations may appear extended at current levels, but the data suggest that at present at least, the specific risk of profit-warning led volatility appears modest, Exhibit 2. The stability in 2016 earnings forecasts has been supported by a significant recovery in major commodities markets and indirectly by global monetary policy, notably in the US and UK, which has proved significantly easier compared to expectations at the start of the year.

Exhibit 2: 2016 Earnings forecasts stable in US, UK and Europe ex UK

During the last 18 months, equity markets had been closely tracking revisions in earnings forecasts. Now, the link is not so obvious. Markets have rallied over the last quarter while estimates have remained unchanged. The data in fact point to investors’ willingness to accept lower returns (equivalently higher valuations) in an environment where monetary policy is expected to remain looser for longer, as exemplified by the market recovery following the UK’s referendum vote to leave the EU.

Exhibit 3: US equities – decoupling from earnings trends?

From a sector perspective, we note that over the last 3 months, 2016 bank sector earnings forecasts have only fallen modestly in the US (-1%) while declines in the UK (-4%) and Europe ex UK (-9%) have been more severe. We believe expectations are being crimped in the UK by the flattening of the yield curve and even more so in Europe where negative interest rates are being pursued and 10-year risk free rates continue to hover around 0%.

Exhibit 4: 3m Banks EPS revisions – Europe & UK suffering from low or negative rate expectations

While we may have concerns in respect of developed market equity valuations at current levels, the data suggest that at present at least, the specific risk of profit-warning led volatility appears modest at present. The stability of earnings forecasts has coincided with a significant recovery in major commodities markets and also a period where global monetary policy, notably in the US and UK, has proved significantly easier compared to expectations at the start of the year.

However, following the exceptional performance of equities since February, it is in our view key to avoid the temptation to only look at evidence which rationalises the rally. The focus should remain on the risks. In particular, declining bond yields point to falling longer-term growth expectations. In contrast to profits expectations for companies, consensus GDP forecasts for 2016 have continued to decline. The divergence between corporate expectations and the outlook for the whole economy may yet be closed by a new found enthusiasm for expansionary fiscal policy, but at this time this remains highly speculative, at least except perhaps for the UK.

Conclusions

1. Earnings forecasts for 2016 have remained stable during the summer.

2. There is no obvious ‘Brexit effect’ in the UK as upgrades for exporters balance downgrades for domestic sectors.

3. At current equity valuations, equity investors’ confidence in economic prospects does seem to be running ahead of that of the bond market.