Earnings momentum remains stable for now

It may be the perfect environment for passive strategies as the lack of catalysts during 2017 has led to a continuation of the low volatility yet highly-valued equity market regime. In particular, it has been a robust year for corporate profitability. 2017 earnings growth forecasts remain pinned around 10%. Even while the medium-term outlook for markets looks challenging on valuation grounds as extraordinary monetary stimulus is unwound, those looking for a significant correction in the short-term should beware as corporate earnings trends remain robust at present.

Given the strong flows into passive vehicles such as ETFs, the absence of market events so far during 2017 has made beating the overall market challenging for active managers. While we continue to see some weakness in the economic surprise indices, Exhibit 1, this has not fed into any meaningful change into the weighted average earnings estimate for US or European markets in recent weeks.

Exhibit 1: Global economic surprise indices

In FX markets, the standout performer in recent months has been the euro, supported by a narrowing gap between US and Eurozone economic expectations for 2017, Exhibit 2. Euro appreciation of as much as 7% since April, which would normally have been a significant headwind for eurozone earnings forecasts seems to have been easily absorbed as GDP forecasts have risen over the same period, Exhibit 3. Eurozone earnings forecasts have in fact rebounded modestly over the last 6 weeks and are once again close to their highs for the year, Exhibit 4.

Exhibit 2: Converging US and eurozone 2017 GDP forecasts

Exhibit 3: Eurozone estimates – no surge in downgrades (to date) as euro appreciates

Exhibit 4: Weighted average earnings forecast index stable

There has over the last six weeks been little change in earnings forecasts in the US or UK on a weighted average basis, despite the significant declines in economic momentum as measured by surprise indices over the same period. The equal-weighted measure, Exhibit 5, however suggests a modest slowing of earnings momentum amongst small and mid-cap companies since the peak at the end of Q1. We would be inclined not to read too much into this trend at this stage as the total decline is small, at around 1% compared to a 10% earnings growth forecast for the year.

Exhibit 5: Equal-weighted forecast index suggestive of modest loss of momentum in US and UK mid-caps since Q1

Based on the updated data we have to hand, we continue to believe global markets are set to trade at best sideways based on relatively high valuations, a tightening trajectory of US monetary policy and stable earnings forecasts. If the US Fed sticks to its current course, we may even see an uptick in volatility in Q4 until investors are able to form a view on profits expectations for 2018. However, the primary concern in the short-term remains an absence of upside, which is similarly reflected in the near-record skew in the options market as investors sell upside exposure to generate yield.