Earnings estimates: Marginal declines could point to trouble ahead

Outside the US, most equity sectors have suffered modest downward revisions to 2018 earnings forecasts over the past four weeks. Within the US, 2018 earnings forecasts are effectively unchanged over the same period. It is too early in our view to be certain that this loss of momentum in non-US estimates is the start of a downtrend but it is consistent with the recent sharp declines in industrial commodities. The good news for 2018 – such as US tax cuts and continuing Eurozone expansion was always in our view a H1 phenomenon. The more challenging narratives such as rising US interest rates were in contrast likely to endure for longer. Furthermore, trade war uncertainty has reached a new peak.

Median 2018 forecasts for Europe ex UK, the UK and emerging markets have moved slightly lower during the past month. While we would not read too much into a single month’s data the clear majority of sectors in these regions have suffered downgrades over the period. In addition, industrial metals prices have been falling, lending weight to the idea that a modest loss of momentum in the near-term cyclical direction of the global economy may have occurred. The very poor performance of China’s stock markets in 2018 and recent weakness of the renminbi are developments which all investors should be watching in our view.

Exhibit 1: Modest decline in median 2018 earnings forecast outside US during June/July

These early suggestions of a decline in economic momentum outside the US coincide with increasingly elevated uncertainty in respect of trade relations between the US and the rest of the world. In recent weeks there has been escalation of tariff rhetoric from US President Trump with threats to place punitive tariffs on effectively all China’s imports to the US. Trump has also commented negatively in terms of the terms of trade between the US and Europe. There is now a possibility, given the lags involved, that the trade war is already responsible for a chilling effect on global business activity.

Exhibit 2: Hiccup in industrial metals prices over same period

If this is the reason for the modest slowdown, while Trump’s trade strategy may appear to some to be ultimately damaging to US interests in the long-term, this strategy is a key part of the package of populist measures which appeals to his supporters. Unfortunately for investors, such policies are therefore unlikely to be given up easily.

Furthermore, Trump’s recent comments on US interest rate policy and the strength of the US dollar characteristically breaks previous conventions on the independence of the Fed and not commenting on the US currency. However, instead of projecting strength, these comments hint at the weak link in the US negotiating position on trade. At present, the US stock market is the best performer year-to-date. It would be reasonable in our view to assume that domestic support for a lengthy trade confrontation would weaken considerably in the event of a correction in the S&P500.

Exhibit 3: US tax cuts have driven EPS forecasts and relative performance in 2018 YTD

Strong profits growth has been a key part of the resilience of equity markets in 2018 even as monetary policy is normalised and a US trade war has materialised. Although one month’s data is insufficient to determine a trend, we see no reason to move away from a cautious positioning on equity markets which have, outside the US, only moved sideways or lower in US dollar terms year to date.