Energy drives estimates higher – but oil now under pressure

While it may seem that global investor sentiment has broadly improved over the last 3 months, following the rapid recovery in equity markets, returns have been dominated by the energy sector, Exhibit 1. With Russia and Saudi Arabia now discussing production increases to head off a loss in market share to US shale, this momentum in the oil price may now ease. Separately, despite volatility in emerging markets we note that profits forecasts have been largely stable in 2018, suggesting that any underperformance is due to the rising dollar rather than weakening profits trends. In developed markets, the median 2018 earnings estimate in the US continued to rise over the last month while in Europe and the UK estimates are stable, despite a marked slowdown in the economic data.

Exhibit 1: Energy sector key driver of global market rebound. Returns shown in USD

Cutbacks in supply and an improving demand picture have led to a remarkable rally in the oil price over the last 12m. It is by no means clear however that the restraint in Russian and OPEC supply is sustainable or even strategically rational in the medium-term.

A $20/bbl increase in oil prices since February was in our view sufficient to create a dampening of demand and drag on the economic performance of net oil consumers such as Europe. In addition, the Vienna-agreed OPEC supply cutbacks were due to expire after 2018. Press reports indicate that an increase in supply is already under discussion, even before the June OPEC meeting. With the US staging a considerable production recovery OPEC members will be concerned not to lose market share. Notwithstanding the upcoming IPO of Saudi Aramco which may suggest a strong incentive for Saudi Arabia to maintain a high oil price, with supply increases under discussion the energy equities are unlikely in our view to sustain the strong outperformance of the last three months.

Outside the energy sector, the median earnings forecast has remained stable in Europe and the UK over the past month and increased modestly in the US. Profits growth forecasts of near 10% for Europe and the UK, and 17% for the US remain intact even if market volatility has increased in recent days.

Exhibit 2: Median 2018 earnings forecast rising modestly in US, stable in UK and eurozone

For emerging markets, our aggregates show that while there have been very modest declines (1%) since the peak reached in January, consensus forecasts are still indicating 15% earnings growth for the median emerging market equity during 2018, towards the upper end of the range this decade.

Yet there is clearly concern in the market in respect of the traditional correlation between tighter US dollar funding conditions and emerging market performance. Given the robustness of estimates, recent declines in emerging market assets appear to be a correction from over-exuberance earlier in the year and possibly rising expected returns worldwide as US monetary policy is normalised, rather than any meaningful deterioration in fundamental profits performance.

Exhibit 3: Emerging market earnings revisions index also stable

More generally, we view the still-strong set of earnings growth forecasts for global equities in combination with sideways-moving markets as further evidence of a thus far benign equity valuation de-rating process as monetary policy is normalised. Some investors may wish to speculate on a global slowdown induced by rising interest rates, but we would prefer to see it in the data before becoming more bearish. For the oil sector however, the period of outperformance may be behind us.